1.7 Tools: The Strategic Profit Model
In the 1920s, the financial analysts at DuPont Chemical broke down the two ratios that top management was always watching: return on assets (ROA) and return on equity (ROE). The goal was to come up with a way to show how—and how well—a firm earns returns. Figure 1-5 shows what was then dubbed the DuPont Model and is now frequently referred to as the Strategic Profit Model. The areas most impacted by purchasing are highlighted in purple.
We will focus on the ROA calculations. By working backward from ROA, you can identify how your decisions will affect your firm's ability to generate returns. You can also compare alternative decisions to see which will provide better returns. This will help you know which decision-making lever to pull to achieve desired results.
The Logic of the Strategic Profit Model
To understand how the Strategic Profit Model works you need to remember three key points.1
Key Components. The key point that you need to remember is that the Strategic Profit Model breaks ROA into two main components: profit margin and asset turnover (or speed).
Key Information Sources. Another point to remember is that the information on the top (margin) half of the model comes from the income statement. The information on the bottom (asset) half comes from the balance sheet.
Key Goals. If you can increase your margin or can convert assets into sales faster, you can increase your return.
Let's walk through the Strategic Profit Model to see how it works. Figure 1-6 plugs the information from the sample financial statements (see Table 1-2) into the Strategic Profit Model. Note that most purchasing decisions affect the COGS and asset levels on the far left (input) side of the model. As you work to the right, you begin to see how your decision affects the issues top management cares about; i.e., margin, asset utilization, and ROA. Using the numbers from the income statement and balance sheet above, your baseline—or starting position—yields an ROA of 10%.
| Income Statement | Balance Sheet | |||
|---|---|---|---|---|
| Sales | 100,000,000 | Assets | ||
| - Cogs | 68,750,000 | Cash | 10,000,000 | |
| Gross Profit | 31,250,000 | + Accounts Receivable | 10,000,000 | |
| - Logistics | 5,000,000 | + Inventory | 10,000,000 | |
| - Sales & Administrative | 18,250,000 | Total Current Assets | 30,000,000 | |
| Total Operating Profit | 8,000,000 | + Fixed Asets | 20,000,000 | |
| - Interest and Taxes | 3,000,000 | Total Assets | 50,000,000 | |
| Net Income | 5,000,000 | |||
| Liabilities | ||||
| Current Liabilities | 10,000,000 | |||
| + Long-term Debt | 20,000,000 | |||
| Total Liabilities | 30,000,000 | |||
The Strategic Profit Model Exemplified
Now, let's assume your firm has not paid a great deal of attention to purchasing in the past. As you analyze your purchasing organization, you decide to adopt the following best practices:
-
Standardize Redundant Parts: You know that over time, your engineering team has designed different parts to perform the same function. You think that reducing redundancy in those parts can help reduce waste and save money.
-
Aggregate Spend: You know that you currently buy many items from different suppliers. By aggregating your spend, you know you could take advantage of volume buys and negotiate lower prices.
-
Strategic Alliances: You believe that if you classify suppliers according to their importance, you can build closer relationships with your most important suppliers, thereby reducing transaction costs as well as the price paid for purchased materials.
Overall, your analysis indicates that these three practices will help you to reduce your cost of purchased goods by 10%. What is the impact on your firm's ROA? Figure 1-7 shows the answer.
The Margin Effect
On the margin side of the strategic profit model, only COGS changes, dropping by 10% (68,750 × .9=61,875). That increases gross profit to $38,125,000 and net income to $11,875,000. However, because income goes up, so does your tax bill. Your accountants tell you that your taxes will increase $1,375,000, making taxes and interest $4,375,0002. Adding these expenses to total operating costs of $23,250,000 increases your total expenses to $27,625,000, which you subtract from gross profit. Your net income is now $10,500,000 and your profit margin is 10.5%.
The Efficiency Effect
Now, let's look at the asset portion of the model: The only change occurs in the value of the inventory—it is 10% lower (i.e., $9,000,000). So, current assets are now $29,000,000 and total assets are $49,000,000. Your asset turnover improves slightly to 2.04.
The bottom line: Reducing the cost of purchased goods improves both your margin and your asset turnover, yielding a new ROA of 21.42%. Of course, as you implement your new purchasing strategy you need to track actual cost changes to verify and document both your savings and your improved financial performance.
If you want to talk through this example to review how the strategic profit model works, watch the following video:
Want to try our built-in assessments?
Use the Request Full Access button to gain access to this assessment.