4.7 Tools: The Strategic Profit Model

You are convinced that moving online and enabling customers to order direct is a good idea. Customers would receive smaller, more frequent orders delivered by Fed-Ex, UPS, or USPS. Based on Amazon's experience (shared above), you know that your shipping costs will probably go up when you move to a greater online presence. In fact, Amazon, a huge shipper compared to Eco, pays $2-$8 to ship a typical order. 1 Although you expect some of your B2B customers to still place larger, weekly orders, many customers take advantage of the Internet's ease of ordering to place smaller orders. Unlike Amazon, you will not provide free shipping (at this point), but will offer flat-rate shipping for certain dollar amount orders. Even so, you estimate that because you will be subsidizing the delivery costs, your overall transportation costs will go up by about 15%. What is the impact on Eco?

Let's walk through the Strategic Profit Model to trace how your decision would influence ROA. 2 Figure 4-4 plugs in some basic information from Eco's financial statements. The strategic profit model breaks ROA into two main components: profit margin and asset turnover (or speed). The higher your margin or the faster you can convert assets into sales, the higher your return. Thus, the information on the top (margin) half of the model comes from the income statement. The information on the bottom (asset) half comes from the balance sheet. Note that most logistics decisions, including this one, affect the operating costs and asset levels on the far left (input) side of the model. As you work to the right, you begin to see how your decision affects the issues top management cares about; i.e., margin, asset utilization, and ROA.

Let's go back to your key question, "What happens when transportation costs go up by 15%?" Figure 4-5 shows the answer. On the margin side of the strategic profit model, only supply chain and logistics expenses change. Transportation goes from $714 to $821 ($714*1.15). That increases total logistics costs to $1,521 and total operating expenses to $3,819. However, because income is reduced, so is your tax bill. Your accountants tell you that taxes are lowered to $451 (from $480), making interest and taxes $460. Adding these expenses to total operating costs of $3,819, and your total expenses are $4,279, which you subtract from gross profit. Higher expenses reduce net income to $622, lowering your profit margin to 6.28%. Now, let's look at the asset side of the model. There is no indication that you will be increasing any fixed or current asset investments. So, asset side of the model is unchanged. The bottom line: Moving to online increases transportation costs, which reduces profit margin and return on assets. Clearly, nobody is going to be happy with this outcome, especially senior management. You need to figure out how to offset the higher transportation costs driven by the decision to build an Internet presence. You have two options: Document increased sales or reduce costs somewhere else.

To review how the strategic profit model works, watch the following video tutorial:

Because you believe Internet sales will improve the customer experience, you and the VP of Logistics meet with the VP of Marketing to try to determine how Internet sales will affect customer satisfaction and buying behavior. The VP of Marketing believes that sales will go up by 10%. As you discuss what this really means, you note the following:

• Transportation costs are likely to increase by 20%—more than you estimated.

• Inventory and warehousing cost will be flat due to distribution center consolidation.

• Marketing expenses will only go up by 5%.

• Administrative expenses will remain unchanged.

You like what you hear, but it sounds complex. Let's walk through the numbers using the strategic profit model, beginning with the margin side of the model. The big driver is increased sales. They increase by 10% to $10,901 (i.e., $9,910×1.10). Now, if we are selling more goods, your cost of goods has to increase accordingly. So, COGS goes up to $5,510 ($5,009×1.10). Your new gross profit is $5,391. Other costs also increase, starting with a 20% increase in transportation. Your new transportation costs are $857 ($714×1.2). Because you are improving efficiency, no other logistics expenses increase. But, your marketing costs increase by 5% to $819 ($780*1.05). Finally, since your sales grew faster than costs (a good thing), so does your tax bill (from $480 to $560). Thus, your new interest, taxes, and total operating costs are $4,463, which means your net income is now $928. Your profit margin improves to 8.51%.

Now, let's look at the asset side of the model. You are confident your inventory won't change. Accounts receivable might change, but more people pay for online orders by credit card, even in the B2B world. Thus, receivables may actually go down. You decide to leave receivables unchanged. You see no reason to change the cash on hand. So, all of your assets stay the same. The good news: You are supporting more sales with the same assets. So, your asset turnover increases to 2.09. When you multiply your higher margin by the larger turnover, you increase your ROA to 17.78%. You like this story much better, but before you start trying to convince others that your strategy is worth pursuing, you'll want to assess whether these changes to the cost structure are believable based on real evidence, not just the VP of Marketing's opinion.

To review the mechanics of the strategic profit model, watch the following video:

Before proceeding, you meet again with logistics VP to get her prespective. You really don't feel comfortable promoting an omni-channel strategy that shows only increased logistics costs. As you discuss the implications of selling on-line, she tells you that she thinks that as more sales occur online, Eco can probably take advantage of the following distribution efficiencies:

• Reduce and consolidate distribution

• Reduce inventory

• Reduce leased warehouse space

After running the numbers, you decide that overall inventory and warehousing costs should go down by about 25%. These costs benefits should help offset the 20% higher transportation costs. What should you do? Based on these assumptions, plug the numbers into the strategic profit model and see what you come up with. Be sure to return to the base model (i.e., the original balance sheet and income statement) before adjusting all of the numbers. Remember that you are actually reducing investment in inventory by 25%.

By the way, the process of considering and comparing alternative possible futures is a type of scenario analysis. Scenario analysis is a tool you want to put in your decision-making toolbox. The ability to present and discuss intelligently (i.e., explain the assumptions) different "what-if" scenarios will increase your credibility. Remember to speak the language of your audience. If you are meeting with senior managers, focus on the key top-line and bottom-line impacts. You may even want to bring your strategic profit model as a backup—just in case someone wants you to talk through the numbers.