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ROS/RMS Author: Gisele Garraway March 1998.

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Presentation on theme: "ROS/RMS Author: Gisele Garraway March 1998."— Presentation transcript:

1 ROS/RMS Author: Gisele Garraway March 1998

2 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

3 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

4 ROS/RMS Graph ROS/RMS is a diagnostic tool used to compare a business unit’s actual profitability to its potential profitability. 30% $150MM 25% Revenue 20% Cabot Normative band (Predicted potential profitability) Profitability 15% 10% Currier 5% Eliot Dunster 0% 0.1 0.2 0.5 1 2 5 Relative Market Share

5 Profitability (y-axis)
ROS/RMS Components There are three main components of an ROS/RMS graph: profitability, relative market share and the normative band. Profitability (y-axis) RMS (x-axis) Normative band What is measured: Current profitability Accumulated experience and strategic position Range of predicted profitability How it is measured? return on capital employed return on equity return on assets return on sales* Relative market share (RMS) Plus and minus one standard deviation from regression line Scale: Linear Logarithmic** * This tool is typically called ROS/RMS since ROS is the most common profitability measure used **Allows for easy viewing of a doubling in relative market share

6 ROS/RMS Relationship Companies with higher relative market share tend to have more accumulated experience. Higher accumulated experience gives the potential for lower costs and higher profitability. Higher accumulated experience is positively correlated with RMS Higher accumulated experience provides an opportunity for lower costs and higher profits RMS is a proxy for accumulated experience. RMS is positively correlated with profitability Accumulated Experience RMS Accumulated Experience Cost per unit RMS Profitability

7 Importance of Market Share
Using relative market share as a predictor of profitability is supported by empirical evidence. The PIMS database demonstrates that, on average, across industries, companies with greater market share have higher profitability. Source: PIMS (Data from 1970 to the present of 3,200 businesses - 66% manufacturing, 20% consumer businesses, 14% services)

8 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

9 Computers & Office Equipment Electric & Power Equipment
Applications Bain has used ROS/RMS effectively for many clients. Examples of Bain work are: Computers & Office Equipment Electric & Power Equipment Situation: A major PC manufacturer recently suffered significant operating losses and was experiencing severe cash flow problems An electric & power equipment company was evaluating a manufacturer of discrete semiconductors for purchase. The client was concerned about industry cyclicality and whether the target’s profit margins were unsustainably high Result: Bain used ROS/RMS analysis to examine the PC industry and found that moving the client into the normative band through operational improvements would result in a $174MM profit before tax improvement RMS/ROS analysis revealed that the target’s margins reflected its market share position and accumulated experience and were therefore sustainable; the target’s high RMS helped drive EBIT margins in excess of 20%

10 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

11 ROS/RMS Steps There are five basic steps involved in ROS/RMS analysis:
Key Success Factors Define the business Determine the economic boundaries of the business Identify relevant competitors Calculate profitability Achieve comparability across competitors Calculate relative market shares Include any shared experience If business is local or regional, weight market shares Draw normative band Calculate the normative band using regression analysis Determine action implications Determine if strategic or operational improvements are required

12 ROS/RMS Steps Key Success Factors
Define the business Determine the economic boundaries of the business Identify relevant competitors Calculate profitability Calculate relative market shares Draw normative band Determine action implications

13 Defining the Business Effective ROS/RMS analysis depends on correctly defining the economic boundaries of a business. Cost sharing and customer sharing are the primary determinants of business definition. High One business with potential for differentiation or niche position (Cross pens and BIC pens) One business (charge cards and credit cards) Separate business with potential for cost leadership (oil and refinery by-products) Cost sharing Separate businesses with potential for bundling (touring quality microphones and speakers) One business with potential for substitution (milk cartons and glass milk bottles) Separate businesses (beer and distilled spirits) Low Low Customer sharing High

14 Correct Market Share Measure
Determining whether a business is local, regional, or national is also important. Incorrectly defined business National discount department store Correctly defined business Regional discount department stores R-squared: 0.31 0.96 When business definition is correct, there is a meaningful predictive relationship *Statistical market areas

15 Relevant Competitors - Incorrect Business Definition
An incorrect business definition may exclude relevant competitors from ROS/RMS analysis. National Textile Laundering It appears Gibb has three major competitors and is underperforming

16 Relevant Competitors - Correct Business Definition
The correct business definition will ensure that all relevant competitors are considered. Regional linen laundering Regional healthcare laundering Regional industrial laundering Gibb has six competitors. Gibb is in three separate businesses, all of which are regional.

17 Calculate profitability
ROS/RMS Steps Key Success Factors Define the business Calculate profitability Achieve comparability across competitors Calculate relative market shares Draw normative band Determine action implications

18 Calculating Profitability
The profitability measure used varies from case to case. The key is to use a measure that will allow for an apples-to-apples comparison across relevant competitors. ROCE (Return on capital employed) ROE (Return on equity) ROA (Return on assets) ROS (Return on sales) Advantages: Best proxy for return on investments Best proxy for return on shareholders’ investments Eliminates the effects of how assets are financed Easy to collect comparable measures across competitors Disadvantages: Difficult to make comparable across companies Difficult to make comparable across companies Not always clear which asset measures to use (Book value? Before depreciation or after?) Results are sometimes unclear when some competitors command a large price premium Calculation:* Net income after taxes Net income after taxes After tax operating profit Net income after tax Capital employed Average equity Average assets Sales Bain example: Drug store chains Building products Retail department stores Beverage industry *Pre-tax profitability measures are preferable because they exclude any firm-specific tax issues

19 Calculate relative market shares
ROS/RMS Steps Key Success Factors Define the business Calculate profitability Calculate relative market shares Include any shared experience If business is local or regional, weight market shares Draw normative band Determine action implications

20 Calculating Relative Market Share
The relative market share for the market leader is calculated in relation to the #2 player; the RMS for all other players is calculated in relation to the market leader. Market leader’s units sold #2 player’s units sold Leader’s RMS: Any other player’s RMS: Other player’s units sold Market leader’s units sold It is preferable to use units* instead of revenue since we believe accumulated units of experience drive the potential for higher relative profitability *Revenues or points of share can be used when units are not available.

21 Shared Experience (1 of 2)
When potential shared experience is ignored, the predictive power of ROS/RMS is limited. In this example, market share in outboard motors does not explain profitability.

22 Shared Experience (2 of 2)
When the benefits of shared experience with lawnmowers and motorcycles is included, a positive correlation appears. Outboard Motors volume 80% 60% Yamaha 40% 20% Pretax Return on Capital 0% OMC Mercury (20%) Chrysler (40%) 0.1 0.2 0.3 0.4 0.5 0.7 1 1.5 2 3 4 5 6x Worldwide Relative Market Share of Outboards, Including Shared Experience With Motorcycles and Lawnmowers

23 ROS/RMS Steps Key Success Factors Define the business
Calculate profitability Calculate relative market shares Draw normative band Calculate the normative normative band using regression analysis Determine action implications

24 Drawing the Normative Band (1 of 2)
The first step in drawing the normative band is to run a regression on ROS and the log of RMS. We then calculate the best fit, or regression line. Regression output (from Excel) Units (MM) Competitor RMS In (RMS) ROS Regression statistics Cannon 4,960 0.80 -0.22 12.3% Multiple R R square Y = mx + b ROS = (ln RMS) Castle 3,400 0.55 -0.60 10.8% Best Fit Line Adjusted R square Holmes 2,178 0.35 -1.05 4.5% Standard error Peabody 6,200 1.25 -0.22 10.5% Observations 5 Whitman 3,182 0.51 -0.67 8.4% Standard error T- stat P- value Coefficients Intercept 0.1145 0.0154 7.45 0.005 X-variable 1 0.0465 0.0243 1.1913 0.152 *The Bain Graphics Wizard draws the normative band automatically when the RMS and ROS data points are given. It will not however, calculate an R2

25 Drawing the Normative Band (2 of 2)
The normative band is drawn by applying plus or minus one standard deviation to the best fit line. Best fit line (regression line) One standard deviation =  1 n-1 n i = 1 (Xi - m)² Profitability Where, n = number of observations x = observed value m = mean RMS

26 Normative Band The Bain Graphics Wizard will draw a normative band automatically based on the input values of ROS and RMS.

27 Adjusted Normative Band
If we believe that a player has mismanaged its costs and has not gotten the full benefits of its experience, we can exclude it from the calculation of the normative band.* The resulting normative band will be more narrow. *In the Wizard, go to the “Series” menu and select “remove series from normative band.”

28 Determine action implications
ROS/RMS Steps Key Success Factors Define the business Calculate profitability Calculate relative market shares Draw normative band Determine action implications Determine if strategic or operational improvements are required

29 Strategic Positioning Operational Improvement
Action Implications A firm’s position on the ROS/RMS graph helps case teams to determine whether a business should pursue strategic positioning or operational improvements. Strategic Positioning Operational Improvement Examples: Blandford can improve its profitability if it increases its market share and captures experience benefits Peabody is below the normative band; its profitability is low given its relative market share Suggested actions: Growth strategy Mergers and acquisitions Cost reduction strategy

30 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

31 LAGTEL* - Background Bain used ROS/RMS analysis to develop a strategy for a wireless telecommunications business. Situation: LAGTEL is a $6B telecom player. Wireless infrastructure is a $2B business unit of LAGTEL, and it is the only “star” business in LAGTEL’s portfolio. All other business units are dogs. Complication: The wireless infrastructure division’s profitability is falling amid rising overcapacity in North America. Management expects that the over-capacity will continue to drive prices downward. Moreover, LAGTEL’s returns are 2% while four competitors earn in excess of 10% operating margins Question: How can LAGTEL improve its long-term profitability? *Disguised client case

32 LAGTEL - Background The profitability vs. overall scale did not demonstrate or clear normative band. 25% 20% 15% 10% 5% 0% (5%) (10%) .1 .2 .3 .5 1 1.5 2 5 10 20 LAGTEL Callums E-tel Lucia Alliance $2B 1995 Wireless Infrastructure revenue Relative Market Share (Total Telecom) Operating Profit Margin Telco Source: Natwest Securities; CS First Boston; Killen & Associates; Wireless Operating Plan

33 LAGTEL- Wireless RMS The team “peeled the onion” and found a stronger relationship between wireless only RMS and wireless infrastructure profitability. 25% $2B 1995 Wireless Lucia Infrastructure Alliance 20% Revenue E-tel 15% R² = 0.52 Telco 10% Operating Profit Margin Billtel 5% LAGTEL Callums 0% (5%) (10%) .1 .2 .3 .5 1 1.5 2 5 10 Relative Market Share (Wireless) Source: Natwest Securities; CS First Boston; Killen & Associates; Wireless Operating Plan

34 LAGTEL - Technology-Weighted RMS
When RMS was adjusted for the mix of wireless technology, an even stronger relationship appeared. LAGTEL’s profitability was low considering its share, and LAGTEL was considerably behind four key competitors. 20% 15% 10% 5% 0% (5%) (10%) .2 .3 .5 1 1.5 2 5 10 Lucia E-tel Alliance Telco LAGTEL Callums Billtel .1 Technology-weighted RMS* Operating Profit Margin R² = 0.73 $2B 1995 Wireless Infrastructure Revenue * Weighted by manufacturer revenue by technology Source: Natwest Securities; CS First Boston; Killen & Associates; Wireless Operating Plan

35 LAGTEL - Strategic Recommendation
After additional competitor analysis, the team recommended a possible merger with one of the top four players to improve LAGTEL’s profitability. 20% Lucia $2B R² = 0.73 1995 Wireless Infrastructure Revenue 15% E-tel LAGTEL (projected) Alliance 10% Billtel Telco Operating Profit Margin 5% LAGTEL (current) 0% Callums (5%) (10%) .1 .2 .3 .5 1 1.5 2 5 10 Technology-weighted RMS* *Weighted by manufacturer revenue by technology Source: Natwest Securities; CS First Boston; Killen & Associates; Wireless Operating Plan

36 LAGTEL - Regression Predicted Synergy Values
The team used the ROS/RMS regression to predict the synergy value of possible competitor combinations. The synergy values ranged from $1.2B to $2.3B. Source: Bain ROS/RMS Regression Model

37 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

38 Pillz* - Background Bain used ROS/RMS analysis to understand the profitability potential of a Canadian drug store retail chain. Situation: Pillz is a leading retailer of pharmaceuticals in Canada. It participates in the sale of prescriptions and over-the-counter drugs in traditional drug stores. Pillz’s management has asked Bain to assist in repositioning Pillz to become the most profitable drug retailer in North America Complication: Pillz’s dominance is being threatened by the entry of non-traditional competitors including food retailers and mass merchants *Disguised client example

39 Pillz - Industry ROS/RMS
The Bain team identified two normative bands: one for food/drug combos and discount merchandisers and another for traditional drug stores. Non-traditional channel Traditional channel 8% 7% $500M revenue Loblaws Pillz Prairies JC PQ 5% LD Pillz ON BC Safeway Pillz Atlantic 3% LD Prairies Regional ROS 1% Wal-Mart Lawtons Atlantic (1%) PP ON (3%) (5%) 0.2 0.4 1.0 2.0 4.0 10.0 Regional RMS Source: IMS, Chain Store Guide, annual reports, Pillz internal data

40 Pillz* - Summary Preliminary ROS/RMS analysis helped the Bain team develop some key insights. Pillz’s profitability (ROS) is highly correlated with regional RMS Pillz’s competitors have significant cost advantages Because the normative band for the non-traditional channel is steeper than for the traditional channel, an increase in relative market share for a non-traditional channel competitor has a greater impact on profitability than the same increase would have for a traditional drug store competitor

41 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

42 Challenges In some situations, ROS/RMS analysis is difficult to conduct. It is difficult to define the business Competition has significant shared experience from other businesses that is difficult to capture in the RMS measure Market shares must be weighted because the business is local or regional One or more sizable competitors are not leveraging their accumulated experience to reduce costs

43 Other Bain Tools Bain uses other tools to estimate potential profitability when RMS or scale is not the profit driver. Key profit driver Bain tool Example industries Customer loyalty Retention Auto insurance Credit cards Advertising Percent of category which is premium priced and relative market share of category High road/Low road Consumer goods toothpaste ready-to-eat-cereals Speed of product development and release Time-to-market Technology semi-conductors Retail fashion athletic gym shoes

44 Agenda ROS/RMS overview Applications ROS/RMS steps Client examples
wireless infrastructure drug retailing Challenges Key takeaways

45 Key Takeaways (1 of 3) Overview
ROS/RMS is a diagnostic tool used to compare a business unit’s actual profitability to its potential profitability ROS/RMS suggests that a firm’s profitability should fall within a predicted range based on its relative market share The ROS/RMS relationship is based on the empirical evidence that high RMS is positively correlated with high profitability ROS/RMS Components Profitability is on the y-axis and is plotted on a linear scale Profitability measures include ROCE, ROE, ROA or ROS. ROS is the most common Relative market share is on the x-axis and is plotted on a logarithmic scale. RMS is a proxy for accumulated experience The normative band is the band in which companies should fall based on their RMS. It is drawn by applying plus or minus one standard deviation to the best fit line.

46 Key Takeaways (2 of 3) The leader’s RMS is calculated as follows:
Market leader’s units sold #2 player’s units sold The leader’s RMS is calculated as follows: Any other player’s RMS is calculated as follows: Other player’s units sold Market leader’s units sold Implications of ROS/RMS Analysis A firm that falls below the normative band requires operational improvements to improve profitability A firm that lies within the normative band can improve its profitability by improving its strategic position and gaining share Challenges In some situations, ROS/RMS analysis is difficult to conduct it is difficult to define the business competition has significant shared experience from other businesses that is difficult to capture in the RMS measure market shares must be weighted because the business is local or regional one or more sizable competitors are not leveraging their accumulated experience to reduce costs

47 Key Takeaways (3 of 3) Other Tools
When RMS or scale is not a key driver of profitability, ROS/RMS is not an appropriate tool

48 Profitability (y-axis)
Takeaway Slides (1 of 2) ROS/RMS Graph ROS/RMS Components Profitability (y-axis) RMS (x-axis) Normative band What is measured: Current profitability Accumulated experience and strategic position Range of predicted profitability Normative band (Predicted potential profitability) How it is measured? return on capital employed return on equity return on assets return on sales* Relative market share (RMS) Plus and minus one standard deviation from regression line Relative Market Share Scale: Linear Logarithmic** ROS/RMS Relationship ROS/RMS Steps Key Success Factors Higher accumulated experience is positively correlated with RMS Higher accumulated experience provides an opportunity for lower costs and higher profits RMS is a proxy for accumulated experience. RMS is positively correlated with profitability Define the business Determine the economic boundaries of the business Identify relevant competitors Calculate profitability Achieve comparability across competitors Include any shared experience If business is local or regional, weight market shares Calculate relative market shares RMS Cost per unit Profitability Draw normative band Calculate the normative band using regression analysis Accumulated Experience Accumulated Experience RMS Determine action implications Determine if strategic or operational improvements are required

49 Takeaway Slides (2 of 2) Action Implications Calculating Profitability
Strategic Positioning Operational Improvement ROCE (Return on capital employed) ROE (Return on equity) ROA (Return on assets) ROS (Return on sales) Advantages: Best proxy for return on investments Best proxy for return on shareholders’ investments Eliminates the effects of how assets are financed Easy to collect comparable measures across competitors Disadvantages: Difficult to make comparable across companies Difficult to make comparable across companies Not always clear which asset measures to use (Book value? Before depreciation or after?) Results are sometimes unclear when some competitors command a large price premium Examples: Blandford can improve its profitability if it increases its market share and captures experience benefits Peabody is below the normative band; its profitability is low given its relative market share Calculation:* Net income after taxes Net income after taxes After tax operating profit Net income after tax Capital employed Average equity Average assets Sales Suggested actions: Growth strategy Mergers and acquisitions Cost reduction strategy Bain example: Drug store chains Building products Retail department stores Beverage industry Calculating RMS Other Bain Tools Key profit driver Bain tool Example industries Market leader’s units sold Leader’s RMS: #2 player’s units sold Customer loyalty Retention Auto insurance Credit cards Advertising Any other player’s RMS: Other player’s units sold Market leader’s units sold Percent of category which is premium priced and relative market share of category High road/Low road Consumer goods toothpaste ready-to-eat-cereals It is preferable to use units instead of revenue since we believe accumulated units of experience drive the potential for higher relative profitability Speed of product development and release Time-to-market Technology semi-conductors Retail fashion athletic gym shoes


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