Dupont Analysis – Understanding what factors affect your profitability

By Patrick Mayoh

A lot of you guys had a look at my article on cloud computing and I really appreciate that. I Hope you agreed with me that, this was a must-have IT applications for organizations wishing to save on capital investments, willing to improve their team’s flexibility and mobility, mindful about the environment and overall desiring to be trendy.

This week I am going to talk about something quite different. But it is still about efficiency, that is focussing on the elements around your organizations or units that really matter to your profitability and productivity overall.

The Dupont model or analysis is one of those frameworks that allow you to see the big picture, compare yourself to competitors in your industry and make informed decisions regarding where and why you allocate financial resources as well as how you can improve those elements that add value to your organization.

The big picture

Traditionally organizations across all industries and sectors measure profitability using such key indicators as ROCE (Return on Capital employed), ROE (return on equity – for investors and shareholders) and ROA (return on assets – how well your company uses its assets relative to its overall performance). While each of those ratios provides analysts with key figures or proportions regarding their organizations, they fail to tell the whole story. This is with regard to individual factors affecting each of the ratios. Take for example the ROE, which is obtained by simply dividing the net income from the income statement by the owner’s equity from the balance sheet. What you end up getting is simply a single figure that does not tell you much apart from how well or bad your company is doing. A Dupont analysis will break down the same figure and give you a clearer picture of what affects (positively or negatively) that measure of your organization.

Say you want to understand what affects your shareholders’ profitability using the ROE, the dupont analysis breaks it down in the following manner:

ROE=Net profit/Equity=Net profit-pre-tax profit x Pre-tax profit/EBIT x Ebit/Sales x Sales/Assets x Assets/Equity

The good thing is you do not need to calculate each of the elements that can be found in either your balance sheet or income statement, so just playing with the same figures around means you will understand which of those between EBIT, Sales, Assets or Pre-tax profits affect the performance of your organization and in this case the profitability of your shareholders.

This equally works when you want to look at those elements affecting your return on investments say for one of your flagship product.

ROI= Net income/Total Assets= Net Income/Sales x Sales/Total Assets

Lastly the profit margin that helps you to know how much sales affect your net income can be decomposed in the following manner:

ROE= Net profit/Sales x Sales/Assets x Assets/Equity

Conclusively each of those figures helps you and your team to understand what individual factors between assets, sales, EBIT, Equity, Net profit affect your performance.

Comparing yourself to competitors

In an age of free access to financial information, it is easily possible for you to gain access to key financial information of your competitors. The Dupont analysis will actually help to make a comparison between what affect your performance and theirs. In terms of benchmarking, you have the opportunity as a business to understand how the leaders positively affect the performance of their organization. As a rule of thumb for example, retail businesses have high turnovers and very low profit margins while service industries like banks make high profit margin with very few assets. Looking at such elements will likely make you understand what you need to improve on or what you need to work on within your organization to do just like or if not better than your competitors.

Assuming your shop does not turn any profit at all. Maybe the problem lies in your sales, although you make good turnover, there is the possibility that you could improve your sales or that your assets are underutilised. Likewise if you are in a sector that need very few assets to turn a profit and assuming you are not getting much return, maybe you need to invest just a little bit more in assets in terms of IT applications or machinery to name just a few. All these appear clearer when you use a Dupont analysis.

Decision making

You only want to invest money where it really matters. Therefore the Dupont analysis is a good starting point when you want to decide as an organization where money should go and why. Also it is a good framework when you have to decide what elements to scrap or maybe those ones which need more attention from your team. Maybe weak sales affect your profitability because of a weak marketing strategy or it is possible your assets are underutilised which explains why you still cannot make the most out of them.

Informed decision making is possibly one of the greatest benefit this model yields to manager when they have to decide where to invest, how and why.

To conclude you always need to understand as a manager why organization makes or does not make profit and the Dupont model is a good framework for that.

References

Bodie, Z., Kane A and Marcus, A.J. (2004) Essentials of Investments, 5^th edition New-York, Mc Graw Hill

Groppello, A.A. and Nikbakjt, E. (2000) Finance, 4^th edition New York, Barron’s Educational Series

Ross, S.A., Westerfield, R. And Jaffe, J. (1999) Corporate Finance, 5^th edition Mc Graw Hill

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The Era of Cloud Computing – Five reasons why your organization needs to adopt it

Patrick Mayoh

I cannot tell why I am turning geeky these days. I had to choose between writing on cloud computing or web 2.0 technologies. The reason I guess is because I believe those two topics just show how much, more efficient IT systems in the future will boost productivity and increase profitability. Cloud computing is one of those IT applications that your organizations should be thinking about for five reasons:

· It is trendy

· It is cost-effective

· It is sustainable

· It is Accessible

· It boosts your team productivity

What is it?

Simply put according to Jacques Bughin et al (2010) in the MC Kinsey Quarterly, cloud computing consists of “accessing computer resources provided through networks rather than running software or storing data on a local computer”. Mell and Grance (2009) of the National Institute of Standards and Technology NIST provide a more comprehensive definition as they define it as “a model for enabling convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction”. Let us see why you need it in your organization and how this will change and possibly improve your business as a whole.

It is trendy

This is one of the hot IT topics nowadays. It is one of those applications that will set the pace of the future and will be widely used by organization for its many benefits. It is gaining such momentum that the MC Kinsey Quarterly devoted a section to it in its article on the top “ten-tech enabled business trends to watch”. Big pharmaceutical giants like Genentech have begun to reap the benefits of cloud computing, as this enables them to design and create documents and spreadsheets from enabled web browsers like Google for example.

IT is cost-effective

Your company spends a lot of money on a yearly basis just to acquire software licences and purchase or maintain computer servers. Cloud computing means your business has a unique opportunity to save in capital investments. If your organization invests in a private cloud, the need to renew say your Microsoft Office licence or your Anti-Virus every year will become irrelevant. Likewise the need to buy servers to support your internal network will also disappear. Cloud computing simply means that if you invest in a private cloud for example, all you need is a reliable and fast enough working Internet connection to access all your files and documents on the “cloud” from your laptop or smart phone. So you can even think about getting rid of all your licences and servers now cloud computing is the new way.

It is Sustainable

Sustainability is one of those terms everyone has become so passionate about in the business world. It is all about how we use natural resources without preventing next generations from doing the same. I think Jim Wallis (2010) gets it better than anyone else. In his book “rediscovering values” he introduces a concept called “the seventh generation” principle whereby American Founding Fathers in the past would make decisions based on how these would affect the next seven generations. According to MC Kinsey Quarterly, the Electricity needed to power IT structures around the world generates greenhouse gases emissions of the scale of countries like Argentina or the Netherlands. This is set to increase by fourfold in 2020. This alone is a good reason why cloud computing is necessary for your business. No need to make capital investments in items such as USB drives, CDs, Servers and paper to name just a few. Because all IT applications can be organized, shared, processed and saved on the cloud using your normal Internet connection; there will not be any need to invest in hardware equipments anymore.

It is accessible

It just used to be something people vaguely knew about but just as Jimmy Harris, Managing director of Accenture Cloud services observes, “More and more money is being allocated to exploring and implementing cloud services; believe it, it is gonna happen and it is gonna continue to evolve”. This is because major software companies like Microsoft and Google to name just those two giants have already developed solutions for clients enabling them to access cloud computing services. Microsoft has devoted a whole platform on its website explaining and clearly outlining the benefits of the cloud for organizations. This just shows that nowadays this is an investment many organizations can venture to make.

It boosts your team productivity

Cloud computing means the IT applications containing your files, spreadsheets and documents can be accessed from anywhere and faster than before. Therefore enhancing your team mobility, flexibility and speeding up the way you deliver services and products to customers or clients.

Maybe you will even cut capital investments in infrastructure like buildings. Because data can be accessed anywhere some of your staff might not have to come to work Monday to Friday. Most of their tasks could be completed from the comfort of their sofas at homes just using their normal internet connection to work on projects.

Also projects could be treated simultaneously as staff can access the same files and documents from the cloud boosting the flexibility and productivity of your team while increasing the speed at which you deliver your services to clients. In an ideal scenario you could get team members from Europe, Asia and Central America to work say on a service or project that is meant for a client in Africa. And this could be done simultaneously using just the cloud and provided those team members can access it from where they are using a normal internet connection.

In a nutshell this is why you can benefit from using cloud computing services. Feel free to leave any comment (I would really appreciate if you did as it only helps me to improve and write about more relevant topics).

References

Jacques Bughin, James Manyika and Michael Chui (2010) ten-tech enabled business trends to watch MC Kinsey Quarterly

Jim Wallis (2010) rediscovering values: on Wall Street, Main Street and your street Howard Books New-York

Peter Mell and Tim Grance The NSIT definition of cloud computing

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Does your organization/department think 20/80?

By Patrick Mayoh

I don’t know if like me you felt disappointed about the last World Economic Forum in Davos, Switzerland. I waited for the whole event to conclude, hoping I would have something really interesting to write about. The theme in itself “turning risk into possibility” was very evocative of Davos’ organizers’ willingness to map the way out from a fragile to a steady recovery. Instead the summit ended on a very strange note. Really what is the use of a week of discussions and debates if all in all what we learn and already know is:

· The recovery will continue to be fragile throughout the West, uncertain in Spain, Portugal and Italy and steady and gaining even more momentum in emerging markets (China, India Singapour, Malaysia, Indonesia.....)

· That unemployment continues to grow and needs to be reduced in the West

· That we cannot speak of a G20 anymore but rather of a G0 where individual countries cater to national economic interests to the detriment of regional or global ones

· Finally that the rising food/commodity inflation will only continue to affect many nations in emerging countries possibly resulting in mass riots across many countries

So I will write about something different and hope you guys find it useful because this is a principle that I particularly enjoy using when faced with a complex situation and I guess this is one of those principles that make problems easier to solve and to understand. So let us speak about the 20/80 principle.

What is 20/80?

According to Rasiel and Friga authors of “The MC Kinsey Mind” this is one of the “greatest truths of business”. 20/80 simply means that 80 percent of an event under study will usually be generated by 20 percent of the examples analyzed. The Italian economist Vilfredo Pareto is traditionally considered the father of this rule. While undertaking a study of the economy of his country he realized that 20 percent of the population possessed 80 percent of the land. Subsequently he observed that 80 percent of his peas just came from 20 percent of his plants. Following from those observations he concluded that “for any series of elements under study, a small fraction of the number of elements usually accounts for a large fraction of the effect”. The same applies to life. 80 percent of the clothes you wear just account for 20 cent the total clothes contained in your wardrobe; and 80 percent of the information you get from TV, Radio, Internet or the papers just come from 20 percent of available information.

Actually when analysing a problem or a situation you will always find some cases of 20/80 that explain why your sales are up, why your team is under performing, why you are underutilizing your resources or why you cannot increase your market share just to name a few instances.

Besides the 20/80 does not necessarily always mean 20/80, it could be 40/60 or something else, what it does mean is that a large proportion of an event can usually be attributed to a smaller proportion of the elements accounting for it (the event).

Benefits of the 20/80 approach

There are many possibilities you could think about when reflecting on the possibility of applying the 20/80 approach to your organization, department or unit. Here we will just look at a few cases and see how the 20/80 rule can be applied and used to drive and increase performance.

For Marketing

When it comes to marketing 20/80 might just mean that 20 percent of your customers account for 80 percent of your revenues. Losing those critical customers might mean a disaster for your business. The one-size-fits-all approach in this sense becomes meaningless as your marketing department should devote its most critical resources on the customers that matter. In fact Curry J. And Curry A. Came up with a marketing model that perfectly exemplifies the rule of 20/80; the Curry Pyramid is a marketing model that recommends segmenting customers according to their profitability to the business.

It is built around the premise that companies that can attract and retain their most profitable customers are likely to be the winners. Traditionally marketing is all about attracting specific clients but the Curry Pyramid actually emphasizes on attracting the most profitable ones not just the most relevant. Therefore, supposing your marketing department thinks about adopting a 20/80 approach, a good point to start will be to investigate where your profits come from and who are the generators of those profits. Say you are a business selling consumer electronics.

Although you have panoply of customers ranging from teenagers to mums at home, you need to find out which of those categories of customers bring more revenues to your store and allocate marketing resources accordingly. In a nutshell 80 percent of your marketing budget should be ideally devoted to 20% of your customers, not literally though as I said before, what it signifies is a marketing department cannot devote the same attention to all customers, actually some customers actually make you lose rather than win money!

How you use your resources

Also what you really need comes into question when you think of the 20/80 rules. Have you considered the possibility of saving cost when you really look into the resources that are actually needed say to manufacture a product or provide a service to customers? Is it possible that you don’t need certain resources in your company at all? Are there elements you could simply get rid of to achieve cost saving? Do you actually need more computers? Have you considered the possibility of cloud computing or cloud networking? When you begin to critically look around your organization, department or unit it is possible that you will begin to see the big picture and possibly spot a few occurrences of 20/80 that need to be addressed to increase profits.

Getting more out of your staff

When you think of the 20/80 principle you can also think about the possibility that maybe 80% of your work gets done by only 20% of your workforce. In which case the first question that comes to mind is “why?” and following from that what could be done to increase the productivity of the underperforming workforce. Maybe you do not need all the people that work for you currently and the opportunity to adjust and retain those that really matter to your organizations while motivating and encouraging those who could bring more to your business will usually present itself.

Dealing with the information overload

I was bemused by the title of one of MC KINSEY’s article “recovering from the information overload”. The article suggests that multi-tasking is actually counter-productive rather than beneficial to an individual. Actually according to a study conducted by Bawden and Robinson (2010) two-third of managers under study have admitted that information overload have actually lessened their job satisfaction while damaging their personal relationships. Another study conducted by Asplund et al (2010) have discovered that when we switch from tasks especially those of a particular complexity we take 30% longer to complete them and make as twice many mistakes. In a world overloaded with information, analyses and report, applying the 20/80 principle definitely make sense. Your organization does not need to have access to all possible information, they are too many out there, and instead you should decide what you think is really relevant to your Business rather than trying to know everything. Do you really need to have a look at that report or figures? How do they even relate to your department or organization? Will they help your business at all? Those are some of the questions needed in the 21 st century overloaded with all sorts of information. MC KINSEY review suggests the 3Fs:

· Focus on what is relevant

· Filter out what you do not need to know

· Forget what is totally irrelevant to your business

That is proper 20/80 actually.

References

Curry, J. And Curry, A. (2000) The Customer Marketing Method: How to implement and profit from customer relationship management, New York: Free Press.

David Bawden and Lyn Robinson, “The dark side of information: Overload, anxiety, and other paradoxes and pathologies,” Journal of Information Science, Volume 20, Number 10, pp. 1–12.

Christopher L. Asplund, Paul E. Dux, Jason Ivanoff, and René Marois, “Isolation of a central bottleneck of information processing with time-resolved fMRI,” Neuron, 2006, Volume 52, Number 6, pp. 1109–20.

Ethan M. Rasiel and Paul N. Friga (2002) The MC KINSEY MIND Mc Graw Hill

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