The Dupont Model: Introduction P.V. Viswanath

Transcript:The Dupont Model: Introduction P.V. Viswanath:
The Dupont Model: Introduction P.V. Viswanath Financial Strategy and Business Decisions What is the Dupont Model? The Dupont Model is an approach to separating out the different sources of a firm’s profitability. According to Flesher and Previts (2013), the name comes from the DuPont company that began using this formula in the 1920s. DuPont explosives salesman Donaldson Brown invented the formula in an internal efficiency report in 1912. The model’s utility is primarily for improving operating profitability, though it can be extended to include financial decisions, as well. It starts with the Return on Assets and shows that this can be decomposed into the product of the profit margin and inventory turnover. We will use the Dupont Model to show the interrelationships between marketing, production and financing decisions. P.V. Viswanath 3 The Du Pont Identity A standard definition of Return on Assets is: Return on Assets (ROA) = Net Income (NI)/Total Assets (TA) ROA = (Net Income/ Sales)*(Sales / Total Assets) ROA = (Net Profit Margin)*(Asset Turnover) Net Profit margin is a measure of the firm’s market power – how high a price it can charge, relative to cost. The focus is on the customer and what the customer wants: the greater the product desirability, the higher the price. The profit margin, as the difference between sales and costs, also reflects the firm’s operating efficiency, i.e. cost control; this suggests a focus on the product and the production process. However, the cost aspect is partly captured by asset use efficiency. Total asset turnover is a measure of the firm’s asset use efficiency – how well it manages its assets Sources of Profit Margin From a customer focus perspective, Profit Margin derives from pricing power, and is influenced by factors such as: product innovation, product positioning, brand name recognition, first mover advantage market niches established marketing channels, customer loyalty, unique supply sources, favorable contracts with customers or suppliers, patents and copyrights. Sources of Asset Utilization Efficiency Asset Turnover measures asset utilization and efficiency, on the other hand, generally comes from the efficient use of property, plant, and equipment; efficient inventory processes Efficiency in the use of working capital. The Du Pont Identity & Strategy The decomposition is a mathematical tautology and is, in itself, worthless. However, its value lies in the implication that the two components of ROA represent two alternative strategies for the maximization of a firm’s profits. In other