A key foundational element discussed in our previous blog, Implementing the use of Key Performance Indicators, can lead to improvements in a company’s bottom line profit. However, a profit number on its own is only part of the story. For sure, it’s better to be in the black than the red, but how much profit is appropriate for a particular business, given the revenue base, scope of operations and capital at risk?
For example, if you loan $100 to an associate to invest in a venture, how much would you want back to adequately reward you for putting that money at risk? If the answer is $125, then the return you seek is 25%. Business owners should constantly be asking themselves this same question when it comes to the money they have at risk in their business. Too often, they do not.
In this article we will look at some ways to measure this return on risk, or Profit Quality.
Return on Sales: “Nothing matters until the cash register rings,” as the saying goes. But what portion of each dollar generated actually falls to the bottom line? Business owners should have absolute clarity regarding how many cents from each revenue dollar is spent on procuring materials, producing the finished product, distributing the product to customers, and performing the marketing, selling and administrative functions that support the business. Key Performance Indicators play a crucial role in wringing out waste and inefficiency from these processes in order to maximize the return on every sales dollar.
Coupled with Return on Sales is the concept of break-even, that point at which sales are of sufficient volume to cover fixed costs, beyond which the marginal contribution (selling price minus variable costs) of each additional sales unit represents profit. The break-even point can be readily calculated as total dollar fixed costs divided by marginal contribution per unit. Our objective is to lower the break-even point either by reducing fixed costs or increasing marginal contribution.
Return on Capital: “Is the profit you are earning a sufficient reward for the capital you have at risk?” Just looking at profit in isolation from the assets and people employed to generate that profit can lead to complacency. From our earlier example, investing $100 to earn a $25 profit may sound like a good investment; investing $1000 for the same return does not. There are two common and relatively simple measures that can be utilized to assess the sufficiency of the reward:
- Return on Investment (ROI): Profit from Investment divided by Cost of Investment
- Return on Net Assets (RONA): Net Income divided by (Net Fixed Assets plus Net Working Capital)
The primary difference between the two measurements is in their application – ROI is typically used to assess individual investment decisions, whereas RONA is more often used to measure the return on the business as a whole. Both are expressed as a percentage, and both keep an owner informed as to whether the profit being earned is sufficient reward for the money at risk in the business.
As a business owner, knowing and then optimizing Return on Sales and Return on Capital will improve Profit Quality. Contact the experts at The Roebuck Group to learn more.