dupont analysis and strategy p.v. viswanath financial theory and strategic decision-making

Dupont Analysis and Strategy

P.V. Viswanath

Financial Theory and

Strategic Decision-Making

Standard Dupont AnalysisROA = NI/TA

= (NI/Sales) x (Sales/TA) = (Net Profit Margin) x (Asset Turnover)

ROE = NI/TE = ROA x (TA/TE)= (NI/Sales) x (Sales/TA) x (TA/TE)= Net Profit Margin x Asset Turnover x Equity Multiplier

Blunt instrument to monitor strategy because The denominator in the ROA includes assets claimed by all providers of capital, while the numerator includes only return to providers of equity.Assets include operating assets and financial assetsNet income includes income from operating activities, as well as interest income and expense, which are the consequence of financial decisions.

Alternative DecompositionThe key is to divide assets into operating assets and non-operating assets, and similarly the liabilities into those associated with the firm’s operations and those that are not.Some of the firm’s long-term liabilities are non-interest bearing, such as pension obligations, which are really part of the firm’s operations rather than its financing.We net the firm’s long-term assets net of these non-interest bearing liabilities to get Net long-term assets.Similarly, we would like to create a category of short-term assets that includes all short operating assets, net of all short-term operating liabilities. This gives us Operating Working Capital, defined as (Current Assets – Cash and Marketable Securities) – (Current Liabilities – Short term debt and current portion of long-term debt).Net Assets = Net long-term assets + Operating Working CapitalNet Debt = Total interest bearing liabilities – Cash and Marketable Securities(Cash is treated as negative debt, which is debatable.)

Alternative DecompositionSimilarly, we isolate and use net operating profit, rather than using Net Income (which includes interest).This is done by adding back interest expense to net income, after adjusting for their tax impact. Similarly, interest income.Thus, we first define (NIntAT) Net Interest expense after tax as (Interest expense – Interest Income)x(1-Tax rate).Then Net Operating Profit After Taxes (NOPAT) = Net Income + Net Interest Expense after taxes; and Net Income = NOPAT – NIntAT.

Alternative DecompositionROE = (NOPAT/Equity) – (NIntAT /Equity)

= (NOPAT/Net Assets) x (Net Assets/Equity) – (NIntAT)/Net Debt) x (Net debt/Equity).

If we rewrite Net Assets as Net Debt + Equity, we get the following:

ROE = (NOPAT/Net Assets) x (1+Net Debt/Equity) – NIntAT/Net Debt x (Net debt/Equity).

Defining NOPAT/Net Assets as Operating ROA and combining terms with NIntAT/Net Debt (which is the effective interest rate after tax on debt), we get ROE = Op ROA + (Op ROA – Eff Int Rate after tax) x (Net Debt/Equity)

=Op ROA + (Op ROA – Eff Int Rate after tax) x Net fin leverage= Op ROA + Spread x Net financial leverage

Alternative Decomposition

Since we are primarily interested in using the Dupont decomposition to help us in operating decisions, we can further decompose Operating ROA.Operating ROA = NOPAT/Sales x Sales/Net Assets orOperating ROA = NOPAT Margin x Operating Asset Turnover

Dupont Analysis Applied

We now try to relate Dupont Analysis to more specific operating strategies of the firm. In this process, we will have to extend the Dupont decomposition even further.

Five Generic Competitive Strategies

Type of Competitive Advantage Being Pursued

Market Target

Lowest Cost Differentiation

Broad Cross-Section of buyer

Overall Low-Cost Provider Strategy

Broad Differentiation Strategy

Best-Cost Provider Strategy

Narrow Buyer Segment

Focused Low-Cost strategy

Focused Differentiation Strategy

How to Produce Cost Advantages

Perform value chain activities more cost-effectively than rivals

Economies of scale; manifests itself in lower COGS/Assets ratio – (better asset utilization)Cost efficient supply-chain management

Reduce inventory costs – (lower assets)Use online systems to achieve operating efficiencies (better COGS/Asset)

Revamp the firm’s overall value chain to eliminate or bypass some cost-producing activities altogether (e.g. outsourcing)

Corporate ExamplesWalMart: streamlining orders, automation of distribution centersNucor Corporation: Using relatively inexpensive electric arc furnaces where scrap steel and directly reduced iron ore are melted. Makes the use of coal, coke and iron ore unnecessary; cuts investment in facilities and equipment (eliminating coke ovens, blast furnaces, basic oxygen furnaces, and ingot casters).Southwest Airlines: no inflight meals, assigned seating; fast online reservation system; automated check-in equipmentQ: How do these activities affect the income statement and the balance sheet?

Differentiation StrategiesIncorporate Product attributes and user features that lower the buyer’s overall cost of using the product.Incorporate features that raise product performance.Incorporate features that enhance buyer satisfaction in noneconomic or intangible ways.Differentiate on the basis of competencies and competitive capabilities that rivals don’t have or can’t afford to match

How to Differentiate

Product R&D activities – improved product design and performance features; e.g. Volvo or BMWSupply Chain activities that affect the performance or quality of the company’s end product. Starbucks has a better product because it has strict specifications on the coffee beans.Marketing, sales and customer service activities that result in superior technical assistance to buyers, faster maintenance and repair services, more and better product information for customers, more and better training materials for end users, better credit terms, quicker order processing etc.; e.g. Maytag

Low Cost Provider Strategy

Striving to achieve lower overall costs than rivals and appealing to a broad spectrum of customer, usually by underpricing rivals.Marketing Tactic: Low PriceOperating Tactic: Economies of Scale

Broad Differentiation Strategy

Seeking to differentiate the company’s product offering from rivals’ in ways that will appeal to a broad spectrum of buyers.Marketing Tactic: General Advertising – need to reach a broad audience; this could be broken down by advertising channel. Higher expenditures on general TV ads, relatively fewer on direct marketing.Operating Tactic: Product R&D


Giving customers more value for the money by incorporating good-to-excellent product attributes at a lower cost than rivals. The objective is to have the lowest costs and prices compared to rivals offering products with comparable attributes.Marketing Tactic: Direct marketingOperating Tactic: R&D, efficient use of working capital

Focused Low-Cost Strategy

Concentrating on a narrow buyer segment and outcompeting rivals by having lower costs than rivals and thus being able to serve niche members at a lower price.Marketing Tactic: Direct MarketingOperating Tactic: Efficient use of working capital

Focused Differentiation Strategy

Concentrating on a narrow buyer segment and outcompeting rivals by offering niche members customized attributes that meet their tastes and requirements better than rivals’ products.Marketing Tactic: Direct MarketingOperating Tactic: R&D



Market Target



Overall Low-Cost Provider StrategyLow PriceEconomies of Scale

Broad Differentiation StrategyGen AdvtgProduct R&D


Direct MktgR&D, efficient

use of wkg cap


Focused Low-Cost strategyDirect Mktg Efficient use of working capital

Focused Differentiation StrategyDirect MktgR&D



Market Target



Overall Low-Cost Provider StrategyWal-Mart, 99 Cent Stores, Dollar Tree

Broad Differentiation StrategyStarbuck’s, Land’s End, Victoria’s Secret


UPS, Budweiser


Focused Low-Cost strategyDairy Queen, Tabasco

Focused Differentiation StrategyTrader Joe’s, Micro-breweries

Strategy Cost Price Quality

Margin

Volume Marketing Tactic

Operating Tactic

Ratio

Low-cost provider strategy

Low Low Low Low High Low Price Economies of Scale; high working capital utilization; high fixed asset utilization

Higher Sales/Net Working Capital; Higher COGS/Assets

Broad differentiation strategy

Medium High High High High Branding; General Advertising; moderately high mktg costs

R&D Higher R&D/Sales; lower Sales/AR; high advertising expenses/Sales

Best-cost provider strategy*

Low-to-Medium

Medium-to-high

Higher Low-to-medium

Medium-to-high

Direct Marketing; low marketing costs

R&D, efficient use of working capital

Focused low costsstrategy

Low Low Low to medium

Low Medium-to-High

Direct Marketing high working capital utilization; moderately high fixed asset utilization

Moderate COGS/Assets, Sales/A/R may not be highbut Sales/Assets are still relatively high

Focused differentiationstrategy

medium Medium-to-high

Medium Medium Low Direct marketing R&D High Direct Mktg/Sales ratio; high R&D/Sales

Five Generic Strategies

A further decomposition?

If we separate Net Income into Sales – COGS – Direct Marketing expenses – General Advertising Expenses – Other expenses, we can write ROA as:Sales/Assets x [1-DME/Sales-GAE/Sales-Other expenses/Sales] – COGS/Assets.The inverse of Sales/Assets can be written as (NWC + Net Long-term Assets)/Sales and NWC can be further broken down, if necessary.

dupont analysis and strategy p.v. viswanath financial theory and strategic decision-making

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