ROI demystified, an instrument to drive growths

I pick one of my favorite topics from my core domain. The #returnoninvestment, commonly known as #ROI, has remained a hot training topic for ages, on which innumerable number of sales people were trained through countless classroom and simulation sessions. I will try to explain simply the basics of financials of a consumer goods distributor and how to use the ROI instrument as a growth tool for a sustainable profitable business.

Let us start with a very common question #WhatisROI?” Is it #profitcalculation and way to search maximum profits, health check of the business, #investmentoptimization, #sustainabilityindex or growth measure? ROI is a set of ratios which indicates the #profitability of a firm in relation to the assets and funds supplied by the owners and lenders. The ratios are crucial from the business owner’s point of view for the financial analysis of the productivity of the assets and funds used in the business. The comparison of these ratios with firms doing similar type of businesses following similar sets of activities with industry average would provide sufficient insight into how efficiently the assets and long-term funds are being used. The higher the ratios, the more efficient are the use of the assets and funds.

It is a simple spread sheet, which facilitates the user to understand the distribution business better. It is also an effective management tool that helps the sales managers and the distributors to make better business decisions while determining the distribution strategy. To have a consistent picture across the year, ROI should always be carried out on an annual basis and not for any given month.

I would try to explain the theme in three easy steps. While using the values and data as examples, I will keep in mind the profile, size and activities of an average distributor of South Asia, South East Asia and Central African markets because the major chunk of distributor-led fragmented trade business is spread across these parts of the world.?

But before getting into the number crunching, we need to understand the concept and purpose of ROI. Why should we do the ROI is more important that what should we do? Let us start with the basics of distribution business. What makes a distribution business going? Broadly two aspects:

• #Infrastructure, which means assets (e.g. warehouse, office premises, manpower, vehicles, finance etc.)
• #CostEffectiveness, means the Gross Profits (i.e. Sales turnover multiplied by gross profit margins) should be greater than the total Cost of Operation (i.e. cost of goods sold, cost of products holding in the warehouse, cost of distributing the products etc.) We can go one step down to separate the fixed and variable costs. If the gross profits are higher than the cost of operation, the business is viable.

Now let me get into the three steps I mentioned before.

STEP 1 – Understanding the ROI Factors

The ROI hinges on three important factors: Revenue, Costs and Capital employed. Let’s see all these three components in detail:

1.???#Revenues: It is the total or gross earning of the distributor from the principal company. Revenue has two components: Gross Profits + Other incomes

a.???#GrossProfits: If annual sales is $10,000,000 and gross margin is 5%, then the gross profit is $(10,000,000 multiplied by 5)/100 = $ 500,000. (equation: annual sales value multiplied by gross margin divided by 100)

b.???#OtherIncomes: If the distributor receives some other incomes from the principal company over and above the gross margins (e.g. performance incentives, annual bonus on achieving targets, subsidies etc.). Let’s assume the distributor gets 0.5% performance bonus and $1000/month as vehicle running subsidy

Hence the Annual Revenue of the distributor is Gross Profit ($500000) + Performance Bonus ($50000) + annual vehicle running subsidy ($12000) = $562000

2.???#Costs: It captures two types of costs, fixed and variable

a.???#FixedCosts: The costs which are fixed in nature and do not directly impact the sales turnover (i.e. rents of warehouse and office, salaries, telephone, electricity, internet expenses, repairs and maintenance, stationary, insurance, bank charges, depreciation of assets, audit fees, staff welfare etc.). It is easier to calculate fixed costs monthly basis; as example rents may be $5000, electricity, telephone, internet all together $700, salaries $8000, repairs and maintenance $300 and all others misc. $500 = $14500/month is fixed costs

b.???#VariableCosts (also known as #DistributionCosts): Unlike fixed costs, these costs are directly proportionate to sales value. Some such costs are sales incentives and bonus, vehicle running expenses (e.g. fuel, vehicle rentals, loading/unloading charges etc.) purchase related discounts to customers, daily allowances, travelling expenses of sales people etc. Variable costs also needs to be calculated in monthly basis; as example total vehicle running costs may be $4400, incentives and bonus $5000, purchase related discounts $7000, daily allowances, travel cost plus other miscellaneous costs $1100 = $17500/month

3.???#CapitalEmployed?(also known as #WorkingCapital): The amount deployed by Distributor (either own money or shareholders fund or loan fund or the combination of two or more) for running the day to day business. The?composition of the capital is the sum of the following:

a.???Value of #paidupstock holding

b.???(+) Account receivable from the Trade (credit offered to the customers)

c.???(+) Account receivable from the principal company (pending claims)

d.???( - ) Account payable to the principal company (dues to be paid)

If the value of paid up stock is $530,000, credit offered to the customers is $50000, claims pending from the principal company is $70000 and due to company (may be for unpaid stocks etc.) is $100,000 then the total capital employed would be $(530000+50000+70000) - $100000 = $550000

All these three factors Revenues, Costs and Capital Employed will now be used in a simple ROI calculation in the next step.

STEP 2 – The #ROICalculation

Now let’s see how these three factors are hinged to each other in the ROI calculation. The calculation has two very simple equations

1.???The first arithmetic has a relation with Cost Effectiveness, we discussed earlier. In this section we find out the Nett Profit (equation: Gross Profit – Total costs = Nett Profit). Remember we mentioned before all calculation of ROI requires to be on annual basis, hence all the costs need to be converted from monthly to annual figures. So from our example mentioned above:

a.???Annual gross profit $562000 (calculated earlier)

b.???Monthly total costs (Fixed plus Variable) = $(14500+17500) = $32000. Annual total costs = $32000 multiplied by 12 = $384000

c.???#NettProfit = $(562000 – 384000) = $178000

d.???#NetMargin (Nett Profit / Sales)*100 =?${(178000/10000000)*100} = 1.78%

The first calculations figures out how much net margin is generated from each sales dollar. Net margin is always expressed in %

2.???The second calculation shows the relationship between #AnnualSales and #TotalCapitalEmployed (calculated earlier). It indicates how many times the Capital Employed has been rotated in the whole year to achieve the annual sales value

a.???Sales/Capital Employed = $10000000/$550000 = 18.18 times

This is an indication of how efficient the business is in utilizing its Capital Employed in generating sales and revenues. This factor is related to rotation of capital, hence is expressed in ‘no. of times’.

Now comes the final part of ROI calculation. We need to multiply the results of first and second calculations. Hence the ROI of the distributor in this case in point will be

1.78% multiplied by 18.18 = 32.36%

We need to understand that ROI is a very broad term. The word ‘investment’ could be Capital Employed, then we calculate #ROCE - Return on Capital Employed (as in the case in point), if it is shareholders’ fund then #ROSF or Loan Fund then #ROLF. If ‘investment’ means total assets (fixed assets + working capital) then the return would be #ROA (Return on Assets). But the fundamentals of the above equation remain same. The only change will be the denominator of the second equation. In place of Capital Employed we need to put the values of shareholders’ fund, loan fund or total assets respectively.

STEP 3 – How to use the ROI instrument as a GROWTH Tool?

We discussed a lot on various data and did a series of number crunching. Principles of ROI suggest that all calculations should be basis actual figures and not on rough statistics. These data should also be on annual basis, not monthly or quarterly. But the problem is not with data or timing. In most cases we find the distributors avoid discussing their returns with the principal company representatives. They are reluctant to share their real figures of revenues, costs and investments. But why do they so? Why don’t they rely on the company people? Such situations arise because there is a trust issue. Despite knowing the ROI calculation and the process fully, the company personnel, in most cases, could not handle the ROI discussion with the distributors in a responsible and trustworthy way. They could not understand a simple fact that ROI is not about calculation only; it is more of mutual trust. It is not an instrument to control the business or regulate the profits rather it is a tool to find opportunities to grow and increase the profits. Hence, along with the clarity of the ROI calculation, it is critically important to learn to use the ROI instrument as a growth tool. Let us spend the last part of this article on that topic.

As the ROI instrument revolves around distributors’ profits, let us have a look on how the distributors make profits. Profits come only through two ways, either by increasing sales or by reducing costs. Hence one needs to constantly search for opportunities to increase sales or reduce costs and the ROI tool could be an effective tool to find those prospects. We will take all those the three ROI factors discussed earlier, one by one.

• Revenue?– Revenue is the gross profit which is directly proportionate to sales. If sales grow, revenue automatically grows. Hence, to grow the revenue consistently, it is imperative to search the sources of sales growth. The four primary sources of growth for consumer products are new geographies, new channels, new products and new services. The ROI data helps the distributor to identify, among these four sources, where the scope for growth lies in his assigned territory. Accordingly the distributor, with the support of the principal company, could define the growth strategy.
• Costs?– Costs are inversely proportionate to profits. Costs could be reduced in two ways. First by reducing the absolute expenses of each activity (e.g. decreasing the warehouse size to reduce the absolute rents or cutting down one delivery vehicle to reduce total vehicle costs etc.) But such direct reduction of costs is not suggested because this will impact the size of the business negatively. With the cutting of a vehicle or a sales person, sales will definitely come down and so the profits. The other way to reduce costs is to increase the output or productivity of each cost area keeping the absolute expenses unchanged. This will work in two ways, firstly it increases the final output (i.e. sales) and secondly it improves the output vs. cost ratio. Some of the examples of this initiative could be increased turnover per shop, which will yield a higher sales value against the same cost of salesman’s salary. Similarly increased productivity per sales person by visiting and ordering in more numbers of shops per day. If a rented vehicle could deliver products to more no. of shops than before, then the productivity of that vehicle increases, in one way that results in reducing the vehicle running costs against the increased sales value. Decreasing discounts could also directly bring down the variable costs of the distributor to add back the saved amount to the net profits. The fixed and the variable costs in the ROI document, if properly analyzed, could be the correct indicators to identify the growth opportunities for the distributor.
• Capital Employed?– Investment is inversely proportionate to profits, but too less investment could also lead to sales loss. One needs to balance the size of the capital employed judiciously to optimize sales and profits. Actions like increased cash transactions (which will reduce the account receivable from the trade and impact positively in bringing down the total capital invested) could directly reduce the cost of capital and add back to net profits. It will also decrease the total capital employed and result in a higher rotation of the working capital.?

ROI is a complex topic, especially for non-finance sales professionals. But the sales people need to understand this tool at a fairly deep level; otherwise they will not be able to leverage it. We have discussed the basics of the tool here. The more we dig deep, the more insight we gain. Intentionally I did not add the actual spread sheet so that the readers would do the whole calculation by themselves. That process of doing by self would definitely reinforce the learning better.

Last but not the least, the ROI is essentially a distributor’s tool, hence he needs to understand and work on his ROI data; because the money, the business and the profits, all belong to him. The principal company can only help him as a consultant to identify the growth opportunities by analyzing the ROI instrument. But for doing so, the most important factor is to have a mutual trust between the company and distributor. Only then we can leverage this instrument to the fullest.