Operationalizing DuPont, Part 2 - Operating Strategies

In the initial article of this series, we delved into a unique perspective on analyzing Return on Equity (ROE) and the DuPont Formula, challenging the conventional approach. Instead of the traditional breakdown of ROE into Return on Sales, Asset Efficiency, and Leverage, we introduced a new method focusing on Return on Assets Invested and taxes. This alternative viewpoint offers a fresh take on evaluating a company's financial performance and efficiency.

Moving forward, the upcoming post will further explore this innovative approach by breaking down the ROAI formula into two main components. By dissecting the formula in this way, we aim to provide a more comprehensive understanding of how a company utilizes its assets to generate returns and navigate the complexities of taxation. This detailed analysis will shed light on the intricacies of financial management and decision-making within a business context.

Moreover, our discussion will extend to the practical application of this refined methodology in evaluating the operational strategy of a privately owned company. By applying the insights gained from analyzing ROAI, stakeholders can gain valuable insights into the company's strategic direction, operational efficiency, and overall financial health. This in-depth examination will empower decision-makers to make informed choices that drive sustainable growth and profitability in a competitive market landscape.

ROAI - Revisited

Recall that ROE can formulated by = (1-Tax Rate) x (ROAI + (Spread x Leverage)) where:

Tax Rate = Tax Expense: Normalized /Earnings Before Taxes

ROAI = Earnings Before Interest and Taxes (EBIT) / Assets Invested (AI, Interest Bearing Debt + Equity)

Spread = ROAI - Cost of Debt where Cost of Debt = Annual Interest Expense / Interest Bearing Debt. The Goal of Spread is to be +2% or higher.

Leverage = Interest Bearing Debt/ Equity

Deconstructing ROAI

ROAI can be 'split' or deconstructed like Return on Equity or Return on Asset. Typically ROAI is deconstructed as:

ROAI = EBIT / AI = (EBIT /Sales) x (Sales/AI)

Using the Dry Bean Income Statement and Balance Sheet as our example (presented below for reference), ROAI is broken down between Operating Margin and Sales Turnover.

Professors Alan Filley and Robert Pricer from the University of Wisconsin – Madison School of Business developed an analytical framework to help entrepreneurial firms align their organizational structure with their operational environment, known as the survival or operating strategies. The key concept is to emphasize the importance of establishing a coherent organizational strategies, structure, and systems that matches the organizational domain.

The organizational domain refers to the range of products and services an organization offers to customers and stakeholders. Entrepreneurs select a structural framework based on the company's mission and vision to address market demands effectively. It is crucial for founders to ensure that the structure aligns well with the operational domain for sustainable success. Misalignment can lead to operational inefficiencies and missed opportunities.

Firms can adopt two approaches to meet market demands: producing standardized products at competitive prices in large volumes (Efficiency Strategy) or offering a diverse array of customized products (Flexibility Strategy). Each approach has specific implications for efficiency, economies of scale, operational leverage, and asset utilization. Each operating strategy suggest specific designs and incentives aligned with the firm's operational context.

Efficiency-seeking firms prioritize reliability and cost efficiency, aiming for standardized processes to meet minimum quality standards. Flexibility-seeking firms value creativity, adaptability, and customer service to meet customer needs through customized design, quality control, and high margins. Below is a summary of key characteristics of each operating strategy:

Identifying your Operating Strategy: Quick Benchmark Vs. An Industry Sample

In the analysis of ROAI, the Operating Margin or Asset Investment usually mirrors a company's operational approach. A firm adopting the Efficiency strategy (also referred to as Strategy Type A) will prioritize the Asset Investment aspect, especially in a market characterized by price competition and few chances for substantial profits. On the other hand, businesses embracing the Flexibility strategy (i.e., Strategy Type B) may charge higher prices for personalized goods or services, requiring a greater investment to maintain these unique offerings.

In Dry Bean's case, it exists in the Coffee Shop industry where operating strategies can vary.

Using a sample of 20 businesses from the iCFO database under Industry Code NAICS 722 for Food and Beverage Establishments, the following comparison is provided in Table 1. Dry Bean is significantly higher in ROE, Operating Margin and ROAI. It is slightly higher than the sample group in the Asset Investment category.

Here are some key findings from this analysis. Initially, it seems that the sample group prioritizes Asset Investment over margin, indicating an Efficiency Strategy where asset efficiency plays a crucial role in driving ROAI. It is evident that Dry Bean outperforms the group mainly due to its significantly higher operating margins. There could be various reasons for this:

• Dry Bean demonstrates excellent management within the sample group, balancing asset investment with higher profit margins.

• Compared to the industry, Dry Bean likely adopts a strategy emphasizing flexibility. Through strategic pricing and efficient asset management, they may gain a competitive advantage.

• The sample group might not be the most suitable benchmark for Dry Bean. Variations in firms within the sample, different geographic locations, and diverse product offerings can make comparisons challenging.

Conclusion

Comparison of ROAI and its components can highlight important insights about a firm and the industry it competes in. In Dry Bean's case, they appear to be a superior performer implementing a Flexibility-type strategy as compared to the sample group.

Table 1 - Dry Bean vs. Industry Sample

		2022
	Dry Bean	Industry
Return on Equity	59.4%	1.3%
Operating Margin	15.4%	5.4%
Sales Turnover	5.17	4.96
ROAI	79.6%	27%

			Deconstruct ROAI
	2020	2021	2022
ROAI	117.8%	75.5%	79.6%
Opearing Margin
EBIT	199	241	354
Divide by:
Sales	1354	1751	2299
Operating Mgn (a)	14.7%	13.8%	15.4%
Multiplied by:
Sales Turnover
Sales	1354	1751	2299
Divide by:
Assets Invested	169	319	445
Sales Turns (b)	8.01	5.49	5.17
ROAI - Check:  a x b	117.8%	75.5%	79.6%

Dry Bean Income Statement and Balance Sheet - 2020 - 2022

		2020	2021	2022
Sales		1354	1751	2299
Cost of Sales		800	1128	1580
Gross Margin		554	623	719
Operating Expenses		355	382	365
EBIT		199	241	354
Interest Expense		17	24	17
EBT		182	217	337
Income Tax		60	87	135
Net Income		122	130	202
Balance Sheet
	2020	2021	2022
Cash	281	73	16
Accounts Receivable	34	180	274
Inventory	68	188	115
Total Current Assets	383	441	405
Machinery and Equipment	129	156	420
Furniture and Fixtures	65	78	90
Accumulated Depreciation	-150	-181	-213
Net Fixed Assets	44	53	297
Other Non-Current Assets	5	5	5
Total Assets	432	499	707
Accounts Payable	254	170	252
Current Portion of L-T Debt	50	76	83
Other Accruals	9	10	10
Total Current Liabilities	313	256	345
Long-Term Debt	41	65	22
Total Liabilities	354	321	367
Owner's Equity	50	50	50
Retained Earnings	28	128	290
Total Equity	78	178	340
Liablities + Equity	432	499	707