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.