The DuPont model’s impact on LSPs and distributors
Tuesday, October 04, 2016
At the end of World War I, a venerable chemical company in Delaware purchased about one quarter of a rising Michigan manufacturing business called General Motors. DuPont's management recognized that new skills were necessary to control its major investment in a mass production enterprise that was substantially different from a chemical business that traced its roots to the making of gunpowder in the 18th century.
DuPont engaged an engineer, F. D. Brown, to develop a new approach to financial analysis. In the early 1920s, it began to apply the DuPont model as a better tool to measure the financial performance of General Motors as well as other businesses under DuPont's control.
The principles of the DuPont model remain as valid today as they were when they were first developed nearly 100 years ago. At the same time, we should recognize that the model has outstanding value and relevance for those executives who supply logistics services, as well as wholesale distributors.
How the DuPont model works
Traditional corporate performance measures place their focus on net profit margins, popularly known as "the bottom line." In contrast, the DuPont model measures return on investment, with the bottom line focused on the relationship between asset turnover and net profit margins. Figure 1 illustrates a typical DuPont model:
Reading from Column I, the first calculation is to develop gross margin, which is the relationship between sales and cost of goods sold. Both the logistics service provider (LSP) and the wholesale distributor should influence sales by providing outstanding customer service. The typical LSP is not involved in the procurement function, but the wholesaler definitely is. The wholesaler's efficiency in buying goods at the right price is critical in developing a favorable gross margin.
Returning to Column I, the next calculation is to add variable expenses to fixed expenses in order to determine total expenses. Variable expenses are under the control of management, and effective executives will reduce these expenses as much as possible. Some of the fixed expenses are the cost of fixed assets, and both wholesalers and LSPs have the ability to control asset utilization. For example, using assets over multiple shifts will allow fixed assets to be utilized more hours each week.
Moving down in the column, the next calculation is to determine current assets, and this figure is the total of inventory, accounts receivable and other current assets. Wholesale distributors always have the opportunity to manage inventory, and sometimes LSPs also have the ability to control inventories in their care. Accounts receivable are controlled by improving the cycle time between billing and payment, increasing the emphasis on prompt payment of outstanding invoices.
Columns II and III illustrate the calculation of net profit and total assets. Net profit is gross margin minus total expenses. Total assets is the combination of current and fixed assets. The net profit margin is net profit divided by sales, and it can be improved either by increasing sales, reducing expenses or both.
The bottom of Column IV shows a calculation that is peculiar to the DuPont model, and it is a measurement of asset turnover. This is the ratio between sales and total assets. The model illustrates that the ability to turn assets more rapidly can be as beneficial to company performance as the ability to improve profit margins.
Finally, net profit margin is multiplied by asset turnover to create a return on investment in Column V.
Figure 2 shows the same model with dollar performance inserted:
Column IV shows a bottom line of 10 percent, certainly healthy performance by most standards. However, asset turnover is abnormally low, reflecting an unfavorable balance between sales and total assets.
The result is a return on investment of only 4 percent, a number that would not attract the average investor. How can performance be improved? Stay tuned.
How the wholesaler improves performance for clients
The wholesale distributor owns the inventory and has responsibility for sales, and the logistics service provider usually does not. Therefore, the wholesaler can always improve sales by better marketing and/or improved customer service. Because the wholesaler also purchases that inventory, the ability to control cost of goods sold is enhanced.
The wholesaler is also a merchant, with the ability to manage inventories and improve the cycle time or collection of accounts receivable. Therefore, the wholesale distributor can directly control current assets. Management of fixed assets depends on the ability to utilize them more intensively, or possibly to outsource by renting rather than owning these assets.
How the LSP can influence the model
Like the wholesaler, the LSP can enhance sales by providing outstanding customer service. Typically, the LSP is not involved in the actual marketing of the product, but outstanding logistics performance will enhance the marketing effort.
The LSP can have a much more dramatic effect on the amount of fixed expenses. The service provider typically owns or at least controls the warehouses, trucks and other capital equipment needed in the logistics function, which means the fixed expenses for the client can be greatly reduced by hiring a contractor (LSP).
By assisting the client in managing inventory, the LSP can control the amount of current assets. By reducing order cycle time, the LSP can help the client control accounts receivable. The result is that the manufacturer who uses logistics service providers can substantially reduce the total assets employed.
Figure 3 repeats columns III, IV and V with total assets reduced from $250M to $150M, which results in asset turnover of 67 percent, or a return on investment that increases from 4 percent to 6.7 percent:
The opportunity for service providers
It is a sad fact that many LSPs today are obsessed with rates. They believe the only way to attract customers is with low pricing. With the misplaced emphasis on rates, the provider misses the chance to sell something that should be far more important — the ability to eliminate investment in warehouse real estate, delivery vehicles and all of the hardware required for storage and materials handling.
In effect, the provider offers to provide assets that do not appear on the balance sheet. By reducing the asset investment for the client, the service provider can dramatically improve return on investment.
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