The relationship of operational innovation and financial performance—A critical perspective

Abstract
Operations management designs, schedules, and controls organizational processes to increase productivity by using methods such as Just-in-Time (JIT)/Lean Manufacturing, Total Quality Management (TQM) or Environmental Management Systems (EMS). Following implementation, managers generally want to determine the impact of such operational innovations on firm performance. Past studies analyzed financial ratios to prove the usefulness of the operational methods; however, findings are mixed. While some reported positive relationships between operational innovations and financial performance, others found no or inconsistent relationships. Motivated to uncover explanations for said inconsistencies, this paper takes a critical look at the appropriateness of the profitability ratios Return on Asset (ROA), Return on Equity (ROE) and Basic Earning Power (BEP) in determining the impact of a given operations strategy on firm performance. Focusing on JIT/Lean Manufacturing, the relationship between these ratios and inventory management ratios is analyzed. Fixed-effect regression shows that no consistent relationship between ROA, ROE, BEP and inventory management ratios exists. This result may be explained, as the profitability of a firm is affected by at least two factors: results from its operations, and how these are financed (e.g. usage of cheap debt, which enhances profitability). This paper suggests that the impact of an individual operations strategy is difficult to isolate from other firm activities, such as its financial management. Hence, profitability ratios such as ROA, ROE and BEP that aggregate all of a firm's activities may not be suitable metrics to determine the effect of JIT/Lean Manufacturing methods on financial firm performance.