When we discuss performance improvement and KPIs we naturally focus first on operating performance. This can be so productive and exciting that we overlook the other dimension of performance improvement – the productivity of our assets.
The DuPont formula makes the potential leverage from improved asset productivity very clear.
Return on funds employed = Net profit margin X Asset Turns
Large corporations with sophisticated financial management are very familiar with this. Few small businesses review their asset mix regularly if ever, despite the fact that the ones who do outperform the ones that don’t.
My recent article on asking “What if …?” questions has generated great interest. The “what if …” questions I asked in this article focused on operating performance. Now it is time to ask the questions about asset productivity.
All management accountants are interested in working capital management, but it does not attract the attention of line managers to the same extent; it’s just not sexy.
Let’s put the question in a different way. “Can we do the same amount of work with fewer capital resources?”
In my original “What if …” example the questions led to a comparison of the operating performance of North and South. Now it is time to ask the “what if …” questions about asset productivity.
If we start at the highest level, we find that any reduction on net assets, achieved without a reduction in sales, will increase Asset Turns, and have a multiplying effect on ROFE.
Manageable components of working capital and their associated KPIs include:
• Accounts payable or debtors. The usual KPI is Debtors days; that is the number of days of trading unpaid in the debtors ledger at the time.
• Inventory; this could be stock, work in progress, finished goods; the KPI is stock turns expressed on an annual basis, calculated in the same way as asset turns.
• Plant and equipment; the KPI here is the level of revenue generated by the asset. For example, if we consider a plant hire business, each hirable item needs to generate sufficient revenue to cover the cost of ownership and the expense of managing the hire transaction.
If we take the example in the “What if?” model, we can see that North generates asset turns of 2.0 while South is 1.8.
Exploring the comparison, North generates $6,000,000 from $2,500,000 of plant and equipment or 2.4x, whereas South generates $4,000,000 from $1,800,000 or 2.22×. If we ask how much plant and equipment South needs to generate $4,000,000 we calculate $4,000,000÷ 2.4 = $1,667,000.
In other words at first sight South has surplus assets to the tune of $133,000. If the two units are truly similar, South should be able to lift its asset turns from 1.8 to 1.92 by identifying the assets with low productivity, increasing its ROFE from 18 to 19.2%.
This is quite a nice result as long as South does not dispose of assets necessary to do the work, because in that case it would need to hire or subcontract the work done by the asset sold.
Note: You can obtain the full paper with screenshots from bizlearn.biz or download the model to experiment for yourself.
Asset strippers have used this technique for years
They found a badly managed business with low asset turns for its industry, bought it cheaply using borrowed money, sold off the poorly performing assets, and then flicked it back into the market at a higher price. Nowadays they call it investment banking.
There are a few traps for people who take a long-term view of the business, so you can avoid mistakes with a few simple guidelines.
1. Do not cannibalize your own business. You have to maintain your current level of Sales to benefit from the sales of underperforming assets.
2. Don’t contract out the work unless you can get a good price for the asset.
3. Don’t sell the asset unless you really don’t need the people who use it, or you can redeploy them. The world is littered with redundancy programs where people pocket the payment and are rehired because they were still needed, often as contractors.
How can you be confident that your asset productivity program will deliver the results you expect?
Check it using a KPI Model. You can build your own or use the “What if?” model from bizlearn.biz as a base.
Be sure to check multiple scenarios. If you can live with the worst case scenario, that is when everything you do costs more, takes longer and upsets customers, then you can be confident your program will work.
The next paper in this series deals with finding the “Low productivity Assets.”