Incremental Improvement - ROAI, Part 2

As mentioned in previous posts, ROAI and Cost of Debt and Part 1 of this series, Return on Assets Invested (ROAI) can serve as an effective benchmark to measure and monitor incremental improvement in your business.

One of the best starting points for incremental analysis and developing tactics to improve things is to evaluate a variety of scenarios to see the potential impact. Using ROAI as the foundation, recall that:

ROAI = EBIT / Asset Investment, where Asset Investment = Interest Bearing Debt + Equity

Like "Return on Equity" or other profitability and productivity measures, we can deconstruct a broad profitability measure into detailed ratios that more closely reflect the impact of operational decisions.

For instance: ROAI = (EBIT / Asset Investment), can be restated ROAI = (EBIT/Sales) x (Sales/Asset Investment), which is Operating Margin x Asset Utilization.

Dividing Operating Margin further Operating Margin or EBIT/Sales is comprised of:

• (Sales - Variable Costs - Fixed Costs)/Sales.

• Sales $ can be divided into

  • (Price per unit x Volume) and Variable Costs into (Variable Cost per Unit x Volume)
    

Sales volume can be viewed as 1) Customers, 2) Products, 3) Orders, etc. It's important to be able to track the unit component and a related average price per unit. As a result:

EBIT = (Price per Unit x #Units Sold) - (Variable Cost/Unit - #Units Sold) - Fixed Expenses

Variable Costs are a bit more complex. Recall that a variable cost is an expense that changes in proportion to production output or sales. When production or sales increase, variable costs increase; when production or sales decrease, variable costs decrease. There usually is a direct correlation where for one unit of sales volume changes, variable costs directly change based on some ratio to sales.

In some financial or cost accounting reports, the Variable costs of production may be called the “Cost of Goods Sold", "Cost of Revenue", "Cost of Sales", or in some cases where the company doesn't have expenses that can be classified as "Cost of Goods Sold", they may include all expenses under Operating Expenses.

Breaking the overall ROAI ratio into its subcomponents will highlight how changes in various strategies and tactics can move the overall metric in a positive direction. The first scenario is how might changes in prices affect ROAI.

Example - Hypothetical Simple Company

Let's use an overly simplified example to illustrate. Assume a company's results for the year are:

Revenues $500,000 (Price per Invoice $250/Invoice x 2000 Invoices)

Cost of Goods Sold $240,000 (Variable)

Other Variable Expenses $60,000 (Variable)

Operating Expenses $150,000 (Fixed)

Assets Invested $400,000 (Loans, Note Payable, Common Stock, Preferred Stock, etc.)

ROAI for this company would be:

Sales - Cost of Goods - Other Variable Expenses - Operating Expenses = EBIT

$500,000 - $240,000 - $60,000 - $150,000 = $50,000

ROAI = EBIT/ Assets Invested = $50,000 / $400,000 = 12.5%

Suppose the shareholders of the firm suggested that their annual desired return is 20% ROAI. An increase of ROAI by 7.5% (or a 60% increase 20%-12.5%/12.5%} seems unattainable, especially in the short run. How might a firm get to that point?

Strategy - Increase Prices

One way to quickly increase profitability in a company is to raise prices on your products or services offered. However, mention price increases to any entrepreneur and management team and they become gripped with fear, and for good reason:

There are several reasons why entrepreneurs might be hesitant to increase the prices of their products or services:

1. Fear of Losing Customers: increasing prices may lead to a decrease in demand for the product or service. Entrepreneurs may worry that customers will seek alternatives if they perceive the price increase is too high.

2. Competitive Pressures: They may fear that raising prices could make their offerings less competitive compared to others in the market.

3. Customer Perception: Price increases sometimes change customers' perceptions of the value proposition. Entrepreneurs may worry that higher prices could lead customers to perceive their products or services as less valuable or desirable.

4. Brand Image: Price increases can impact the brand image of a company. Entrepreneurs may worry that raising prices could tarnish their brand's reputation as being affordable or accessible.

5. Psychological Barriers: There may also be psychological barriers for entrepreneurs themselves. They may have personal attachments to their products or services and feel uncomfortable with charging more, even if it's justified by market conditions or costs.

To address this 'fear' of raising prices, it's important to run through various scenarios. In the scenario/illustration we'll use, we must remind the reader of the economic concept of "Ceteris paribus" (is a Latin phrase that translates to "all other things being equal" or "holding other things constant" must be discussed). In business and economics, it is used as an assumption or condition in economic models or analysis to isolate the effect of a specific variable on an outcome while assuming that all other relevant factors remain unchanged. It applies when evaluating the impact of price changes.

Application - the Impact of Price Increases

To get to a 20% ROAI, the company would need to improve EBIT by $30,000 or Assets Invested of $400,000 x 20% = $80,000 Less Original EBIT of $50,000. To compute the price increase (again, making the simple assumption that all other variables don't change), we can calculate:

Needed Increase of $30,000 = (New Price - Original price per Invoice of $250/Invoice) x 2000 Invoices, or

(New Price - 250) = $30,000/2000 Invoices

New Price - 250 = $15/Invoice

New Price = 250 + 15 = $265/Invoice or a (265-250)/250 = 6% Price increase needed to obtain a 20% ROAI, all other variables remaining constant.

In this simple example, it would take a 6% increase under the assumptions noted to reach the targeted 20% ROAI. Using these assumptions, assuming no change in number of invoices sold, the increase in Sales due to price increases "drops" $ for $ to the bottom line.

Reality, of course, would add complexity. Some things:

1. A price change would typically have an impact on volume (usually inverse) so one would have to take into account the effect on volume changes with Variable and Fixed Costs. Note, that sometimes a price increase causes an increase in volume if the customer views it as more of a premium item.

2. A change in revenue may not affect the Cost of Goods Sold but probably would affect any variable expenses like Commissions or Advertising Expenses which may related to a change in Sales $.

3. Usually, Fixed Expenses are not affected in the short term if there is little volume change. However, if the volume were affected significantly by a price change, more capacity may have to be added or reduced affecting Fixed Costs like Rent, Depreciation, and others.

4. Asset Investment may be affected. If Accounts Receivable increased due to a change in Sales $, the company may be required to take on Interest Bearing Debt to fund the larger receivables account (or vice versa). Otherwise, the company would need to alter other working capital accounts like Cash, Inventory, or Accounts Payable to change the effect of increased/decreased Accounts Receivable.

Summary

Changing prices on products/services can have a large impact on a bottom-line metric like ROAI. While our very oversimplified example showed a 6% change needed to hit a target ROAI, it didn't take into account the impact on other variables in the ROAI calculation. In reality, the entrepreneur and team would need to evaluate this on a grander scale.

With that said, maybe a firm can increase Prices by 1% or so. It doesn't have to be as large as 6%. Incremental increases each year of 1% may not affect volume or other operational variables. Minor price increases on an annual basis is a great example of how to implement Incremental Analysis and Strategy.