The affect of Process Decomposition on Profit

Carrying on from the previous Blog when I was at Unisys we used demonstrate the positive impact of MRP on a business using Dupont Analysis. The formula developed by DuPont is used by many companies to evaluate how effectively assets are used through measuring the combined effects of profit margins and asset turnover.

There are two main performance ratios associated with establishing a profit model:

1. Return on Equity (ROE) which is used as a general indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its owners. Calculated by (Net Profit) / (Average Shareholder Equity for Period)
2. Return on Total Assets (ROTA) a measure of how effectively a company uses its assets. Calculated by (Profit before interest and tax) / (Total Assets).

You may ask the question why? It really is quite obvious. ROE is a measure of what an investor gets back in monetary terms from the trust he or she puts in the management team of an organisation. Whereas the Return on Assets is a very good measure of how the management team is using the Assets of a company to generate a profit.

ROTA can be used to measure the operating efficiency of the business and is the ratio over which operational management has the most control. There two main drivers that impact ROTA are:

1. Margin on Sales percentage – Calculated by( PBIT / Sales)
2. Sales to Total Assets Ratio – Calculated by (Sales / TA)

If we now drill down on Margin on Sales, there are four main drivers these are Materials, Labour, overheads and Admin/Selling expense. Each of these can be broken down further with their own drivers to provide a means of a more detailed analysis. Likewise if we drill down on Sales to Total Assets the most significant drivers are Fixed Assets, Inventories and Accounts Receivables which again can again have their own drivers defined to increase the operational control over the activities.

A simple spreadsheet model can be created to provide a means of adjusting the drivers to evaluate the impact on ROTA and ROE. Also a 3 to 5 years outlook can be built to ensure that model supports the aspirations of the owners and stakeholders. The cost ratios provide a mechanism to plan, budget, delegate responsibility and monitor the various functions. They can quantify the target for all areas and calculate the affects of disparity in any one of the subsidiary ratios on the overall performance. A simple spreadsheet model can demonstrate the impact of changing driver values on the higher level performance ratios.

This model does not handle very well the detail around variation in different products, material costs, changes in volumes and different asset depreciation policies. There are many good planning tools around that can be used for detailed planning; however, as a first cut the DuPont Model provides an excellent insight into the impact of ratio variations on the profitability of a business.

The E-Business Time Warp

This is a bit of nostalgia from my Consulting days whilst living in Singapore. The organisation I worked for was an Oracle E-Business business partner. As part of my responsibility I was invited by Oracle to accompany some of our prospects to their annual conference in New Orleans. One of the events was based on the Rocky Horror Show where we were all given Tee Shirts that were printed on the back with the words below sung to The Time Warp. The words give you Oracles messages and their competitors at that time most of which have been acquired by Oracle or otherwise disappeared.

RIFF-RAFF

It’s astounding,

time is fleeting,

Madness takes it’s toll,

but listen closely….

MAGENTA

Not for very much longer,

RIFF-RAFF

I’ve got to keep control,

I remember glue-ing the pieces!

Connecting…. ….the moments when,

Application’s would stop working,

and programmers would be lurking….

CHORUS

Let’s glue the pieces again! Let’s glue the pieces again!

RIFF RAFF

You take a piece from SAP….

CHORUS

And then a piece from i2.

DR. FRANK

You put your hands in your pockets.

CHORUS

An integration stew,

and they take so long

It really drives you insane.

Let’s glue the pieces again! Let’s glue the pieces again!

MAGENTA

It’s so dreamy.

Ok, patchwork free me!

So you cann’t see me, no, not at all.

In another dimension, with integration intentions.

Where secluded, I see all.

RIFF RAFF

With a bit of the mind flip.

MAGENTA

You’re into the profit slip!

RIFF RAFF

And nothing can be the same.

MAGENTA

You’re spaced out on glazed donuts!

DR. FRANK

With a sprinkle of walnuts!

CHORUS

Let’s have a latte’ again! Let’s have a latte’ again!

REPRISE:

MAGENTA

Well I was walking down the street, just a-having a think,

when a C-E-O gave me an evil wink.

He shook-a me up, he took me by surprise,

he had a lotto cash and the devil’s eyes.

He stared at me and I felt a change,

time meant nothing, never would again.

CHORUS

Let’s do the Time Warp Again! Let’s do the Time Warp Again!

RIFF RAFF

You take a piece from SAP….

CHORUS

And then a piece from i2.

DR. FRANK

You put your hands in your pockets.

CHORUS

Integrators have no clue,

and they take so long

it really drives you insane.

Let’s glue the pieces again! Let’s glue the pieces again!

DR. FRANK

A bit of Clarify here…

CHORUS

An then some Broadvision there…

DR. FRANK

Peoplesoft and Ariba…

CHORUS

An Integration Nightmare

and it takes so long

it really drives you insane.

Let’s glue the pieces again! Let’s glue the pieces again!

The Profit Model

When developing a Business Process Architecture there needs to be an understanding of the Profit Model being pursued by the Organisation. The process activities at all levels within a Business Architecture support the Profit Model which in turn contributes to the Value Proposition.

There is an excellent book “Key Management Ratios” written by Ciaran Walsh which explains the profit model and the key ratios that support the sustainable profitability of an organisation. Without this understanding it will difficult to build a Business Process Architecture that supports the Organisation's Business Model. In my previous Blogs I discussed the development of core end-to-end business processes through the use of industry specific frameworks. The recording and presentation of the financial success of these frameworks is maintained in the Finance Processes. Below is a diagram of the Cash Flow within a typical commercial organisation. It highlights the fine balancing act required to manage the cash inflows  and cash outflows during a typical production cycle.  

The above diagram shows how the Cash Reservoir supports the core processes and the financial interfaces that manage the cash inflows and outflows enduring there is sufficient cash available to execute a full production cycle.

The diagram below shows how we measure the liquidity of an organisation and provides an end-to-end process measured in Working Capital Days. This can be further decomposed so that responsibility for lower levels of processes into payable days and receivable days that can affect the Time Gap-Cash in/Cash-out and the funding requirements of the organisation,

This example highlights the need for Business Architects to have both and Industry Knowledge and an understanding of the resource requirements of an organisation within the industry sector it operates in.