In a previous blog “Ratio Analysis is KEY to Understanding Process Decomposition” I touched on the DuPont Ratio Analysis technique which is also known as the Strategic Profit Model. The DuPont Ratio Analysis Model is an excellent representation of how KPI decomposition is achieved. Also with its emphasis on Operational Performance it ties key activities to the financial performance of the company.

There are two main performance ratios associated with establishing a profit model:

1.       Return on Equity (ROE) which is used as a general indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its owners. Calculated by (Net Profit) / (Average Shareholder Equity for Period)

2.       Return on Total Assets (ROTA) a measure of how effectively a company uses its assets. Calculated by (Profit before interest and tax) / (Total Assets).

You may ask the question why? It really is quite obvious. ROE is a measure of what an investor gets back in monitory terms from the trust he or she puts in the management team of an organisation. Whereas the Return on Assets is a very good measure of how the management team is using the Assets of a company to generate a profit.

ROTA is used to measure the operating efficiency of the business and is the ratio over which operational management has the most control. There two main drivers that impact ROTA are:

1.       Margin on Sales percentage – Calculated by( PBIT / Sales)

2.       Sales to Total Assets Ratio – Calculated by (Sales / TA)

 

If we now drill down on Margin on Sales, there are four main drivers these are Materials, Labour, overheads and Admin/Selling expense. Each of these can be broken down further with their own drivers to provide a means of a more detailed analysis. Likewise if we drill down on Sales to Total Assets the most significant drivers are Fixed Assets, Inventories and Accounts Receivables which again can again have their own drivers defined to increase the operational control over the activities.

A simple spreadsheet model can be created to provide a means of adjusting the drivers to evaluate the impact on ROTA and ROE. Also a 3 to 5 years outlook can be built to ensure that model supports the aspirations of the owners and stakeholders. The cost ratios provide a mechanism to plan, budget, delegate responsibility and monitor the various functions. They can quantify the target for all areas and calculate the affects of disparity in any one of the subsidiary ratios on the overall performance. I have included a simple spreadsheet model to demonstrate the impact of changing driver values on the higher level performance ratios.

This model does not handle very well the detail around variation in different products, material costs, changes in volumes and different asset depreciation policies. There are different ways of doing this and I will get around to covering these in a later publication. There are many good planning tools around that can be used for detailed planning; however, as a first cut the DuPont Model provides an excellent insight into the impact of ratio variations on the profitability of a business.

 

Profit Model.xls (93.50 kb)

Through the use of the Entity level Business Model I am able to establish the 3 main categories of processes:

1.       Strategic Management Processes

2.       Core Business Processes

3.       Resource Management Processes.

These process categories can be represented in a Value Chain Diagram which illustrates how all the process within an organisation affect profit and create value.  In conjunction with the Value Chain, I would recommend the use of a Benchmarking Framework such as APQC – Process Calcification Framework (PCF).  This is particularly useful for Business Process Management as it provides a standard Nomenclature for distinguishing process categories and their decomposed components.

At the outset of all BPM projects participants should agree a standard convention and nomenclature. It provides a means for all BPM developers and project participants to establish a consistency throughout the project and set a baseline on which future enhancements and improvements can be measured. 

To provide a basis for establishing a Unique Identifier the APQC Process Classification Framework (PCF) provides a standard nomenclature framework of unique identity numbers down to the activity level that is divided into 4 levels.

1.       Category: The highest level within the PCF is indicated by whole numbers (e.g., 8.0 and 9.0)

2.       Process Group: Items with one decimal numbering (e.g., 8.1 and 9.1) are considered a process group.

3.       Process: Items with two decimal numberings (e.g., 8.1.1 and 9.1.2) are considered processes.

4.       Activity: Items with three decimal numbering (e.g. 8.3.1.1 and 9.1.1.1) are considered activities within a process.

Most Business Process Tools require that each element has a unique identifier, which is usually assigned by the software. However, in my opinion it is better to adopt a standard such as APQC – PCF as it provides a classification system for grouping processes and activities and for establishing a performance framework on which to identify areas of improvement and manage future changes.

I have successfully used this framework recently on a WebSphere Business Modeler project, in conjunction with IBM’s Business Component Model. It proved to be an invaluable tool in lining up the business processes and activities to the Component Model structure.