Over 2,000 years ago during the Han dynasty, Qian Sima, a Chinese philosopher, pointed out that small profits but quick turnover is a better strategy than seeking huge margin only. Now in modern times, investors rate the management performance of CEOs and CFOs of manufacturing firms largely by their ability to wring profits from the assets under their control.
As such, return on assets (ROA) has perhaps become the premier metric of quarterly and annual results today.
Management teams are no longer measured purely on growing the top line. Shareholders are increasingly concerned about seeing real returns from the significant investments that have been made in China and elsewhere in Asia.
But it’s not easy when costs are rising rapidly, customer needs are constantly changing and local competitors are rapidly closing the technology gap. How many of the region’s management teams are able to measure and report on ROA at the transactional level of detail?
How many provide their middle-management ranks with accurate, timely, detailed reporting of ROA by invoice line item, production run, customer order or production line which would enable them to follow Qian Sima’s advice?
Virtually none. And what are the chances that implementing systems that are capable of reporting and analysing this data will define the winners in Chinese and Asian manufacturing? Very high.
Room for improvement
The obvious solution should arise from tighter control of realised ROA.
But even today’s ‘advanced’ management accounting systems – including sophisticated activity-based costing (ABC) and enterprise resource planning (ERP) systems – aren’t capable of calculating, reporting, or modelling ROA at a level of detail sufficient to allow managers to know the ROA impacts of their day-to-day, deal-by-deal choices and trade-offs.
As a direct consequence of this weakness, shareholder returns in industries including chemicals, steel, semiconductors, electronic components, paper, packaging, plastics, and several others often fall well below an acceptable rate of return on investor capital.
In China, for example, the ROI of many firms are below the interest rate, which indicates that value is actually being destroyed for shareholders. For example, for a sample of 364 Chinese listed companies, the average ROI was just over 4% in 2011, compared with the average of 6.6% interest rate that year.
Just under 70 companies achieved ROI above the interest rate. These were predominantly non asset-intensive companies, indicating that the manufacturing average is likely to be even lower. Definitely room for improvement.
Back to basics
Before we drill into the details of this problem, let’s go back to basics. First, consider how most well-trained business people think about and define the ultimate goal of any business: profit. The form that profit takes, be it ROS, EBITDA, ROCE, ROIC, RONA, etc, will be dependent on the situation in which the term is to be used.
However, as any Wall Street analyst or finance professor will attest, the ultimate measure of profitability is return on equity (ROE), the ratio of the current year’s profit divided by shareholders’ equity (all accumulated past profits), or profit/equity.
The higher the ROE ratio, the faster total shareholder equity—and stock price—will grow as each year’s profits are added to the stockpile of shareholder wealth.
Unfortunately, even though achieving and sustaining a high ROE is the ultimate goal of any financial strategy, the ROE ratio itself is too abstract and removed from day-to-day business operations to be of any practical use in measuring and managing profitability.
To gain real control over profitability, the profit/equity ratio needs to be broken down into its components.
The most elegant explanation of the three components driving ROE is the famous “DuPont Profit Formula.” In a nutshell, this formula shows how three financial measures interact to yield the ultimate result of ROE (see Figure 1). Control over all three ratios leads to control over the return on equity.
To run a business for optimal profitability, management must focus on the interaction between the profit/sales and sales/assets ratios. Multiplied together, these two ratios compose ROA—the final measure of a management team’s effectiveness in squeezing profits from the assets under their control.
Don’t forget velocity
Of these two vital operating ratios, profit/sales, or margin, is the focus of enormous attention in every company. To calculate the profit margin generated by each unit shipped or each dollar of revenue sold, companies expend huge resources attempting to accurately calculate the full cost of each product type made.
No such claim can be made for the equally crucial sales/assets ratio. Sales/assets, or the velocity ratio, measures the speed at which sales are generated from a company’s asset base.
The arithmetic is simple and unforgiving. Sales/assets, or velocity, is just as important as profit/sales, or margin, in determining a company’s ROA. Margin x Velocity = ROA.
Low-margin products can yield exactly the same ROA as high-margin products if those low-margin products are easier to make and flow through the assets at higher velocities. Conversely, high-margin products won’t deliver a superior ROA if those high margins are offset by slow production velocities.
This idea is fundamental to making the productivity improvements Chinese companies need to make to retain ROE in the face of increasing cost structures.
Beware ‘margins only’ metrics
Maximizing a company’s ROA (and ultimately ROE) requires managers to understand in great detail the trade-offs between margin and velocity product by product, order by order, and customer by customer. This requires that manufacturers need to measure and control the velocities of the products in the same way they do the margins.
But this is often not the case. Production velocity data exists somewhere in the manufacturing organization, usually at the plant level. But it has been too complex a challenge to link detailed production velocity data to margin information in a rigorous way.
Lacking access to robust management accounting systems that can seamlessly integrate margin and velocity data, managers have no choice but to rely on traditional “margin only” metrics.
But shareholders pay for ROA. Furthermore, even though Margin x Velocity = ROA, virtually no manufacturers have systems that can properly take into account the role of velocity in driving ROA. Thus, this becomes a key area of identified improvement for manufacturing companies operating in China and throughout Asia.
To optimize the ROA generated each year from hugely expensive production assets, management teams must make a bewildering array of choices with great precision every day. Those choices can be grouped into four key areas, which are shown in Figure 2.
Let’s take a very simple example of a product mix choice (see Figure 3). Would we rather accept a new order for $1,000 of Product A with its $200 margin above material costs or an order for $1,000 of Product B with its $100 margin?
On a margin-only basis, we clearly prefer Product A. But what if we know that Product A, because of its physical properties, is half as fast as B when running through the rolling mill? In one minute of rolling mill time, Product A will generate $600 (3 x $200), while Product B will also generate $600 (6 x $100).
From an ROA standpoint—generating profit within a given period of time from the assets—Products A and B are equally profitable. But Product A’s higher margin does not translate into a higher ROA.
With margin on the vertical axis and production velocity on the horizontal axis, a profit topographical map shows contour lines that represent levels of cash/profit per minute and ROA. The bubbles can represent products, customers, markets, sales regions, or production facilities.
As illustrated in Figure 3, the topographical map shows a dramatically different view of profitability than a “margin only” approach. High-margin products, customers, etc. may be significantly less profitable and generate lower ROA than ones that are produced faster and generate higher profit per minute (e.g., Product C vs. Product D).
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From this we can see that optimising ROA for 2,000 or 20,000 varieties of products on 40 different production lines is far from trivial. But unless you can measure, report, and model both the velocity of production (sales/assets) at critical manufacturing steps and the margin (profit/sales) of each transaction to compute transaction-level ROA, you simply can’t gain effective management control over your ultimate ROA performance.
Profit velocity tools
Having long recognized that choices based solely on margin can’t, by definition, lead to maximum ROA, dozens of leading manufacturers have been eager to implement a management accounting system that fully integrates velocity and margin metrics at the transactional level.
By allowing managers to model the ROA implications of their choices, before they make those choices, these companies have made significant adjustments to their product mix, customer mix, asset mix, and pricing levels.
Very significant increases in profitability, typically in the range of 3-5% of revenues, have been reported (see Figure 4), which has translated into notable improvements in ROA performance.
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The strategic considerations of integrating velocity into decision making are profound as they guide commercial and operational aspects of the business, including which products a company should push, which customers to target and how to incentivise their sales force.
Implementing profit velocity tools and processes allows multiple functions and application areas to work towards increasing cash contribution and profitability:
- Marketing departments prioritize products with high profit velocity potential, adjust pricing to gain share in prioritized products and evaluate future products by their profit velocity potential
- Sales departments focus efforts on customers purchasing high profit velocity products and link sales incentives to profit velocity levels to maximize profit potential
- Production and finance departments prioritize production lines with high profit velocity performance, avoid CapEx investments by maximizing existing assets and model potential profit velocity and ROA of new investments
The implementation and adoption of profit velocity tools and processes take time and effort. But the uptake and efficacy of implementing velocity tools and metrics is likely to be a key differentiator amongst manufacturing companies operating in China and elsewhere in Asia as they adjust to changing global and local business environments.
A more sophisticated understanding of what truly drives value will enable companies to reap the returns from substantial investments and turn promise into profit.
About the Authors
Michel Brekelmans is a Partner with L.E.K. Consulting and co-head of L.E.K’s China practice. Lane Chen is a manager in the same company.
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