Dr. P.V. Viswanath
Smith's notion of Profit Leveraging and the Dupont Model
P.V. Viswanath, 2013
In this note, we will look at how the Dupont Model could be used to improve profitability. The basic ideas for this analysis comes from Smith (2006). In fact, most of this note is really a presentation of Smith's ideas; what is original is solely the way that I have presented it. Hence I will quote extensively from Smith without indicating this specifically.
The Dupont Model derives from the basic identity, ROE = Net Profit Margin x Asset Turnover x Equity Multiplier, of which the primary part which is relevant for marketing analysis is ROA = Net Profit Margin x Asset Turnover. This is usually interpreted as saying that firms can either choose to focus on increasing net profit margin through branding and other kinds of product differentiation or by focusing on sales volume, which can be done by the efficient use of assets, viz. by increasing asset turnover.
While this first-pass analysis is, no doubt, true and very useful, it is possible to look at this identity with new eyes. For example, if we consider products with high profit margin, then the reduced Dupont Model can be interpreted as saying that the sensitivity of ROA to improved asset turnover is high, since profit margin is high. If so, then this suggests that marketing managers should develop ways to leverage this high profit margin by working on improving asset turnover. Similarly, one could suggest that for products with high volume, managers should try to improve profit margin, since every dollar of profit margin improvement will be leveraged manifold by the existing high volume for the product.
This seems to turn the Dupont model on its head! Is the traditional emphasis correct or is it the revised interpretation that has value? The answer is, as you might have expected, "Both!" That is, the traditional emphasis is valuable because normally firms develop capabilities in either a differentiation strategy or a cost-efficiency strategy. The two corporate cultures are often antithetical and hence this reading makes sense. However, to the extent that a firm with a differentiation culture can increase sales volume efficiently or a firm with a cost-focus culture can increase profit margin, why not?!
Low gross margin strategies:
Low-gross margin players -- and here we use the term "gross margin" to refer to price less variable costs, i.e. marginal profit -- best leverage incremental profits not by driving volume, but by bundling and driving many gross profit opportunities through their customer base in a way that surrounds and serves the customer account in valuable ways. Rather than think of the product as the unit of analysis, the manager should be looking at the customer as the unit of analysis. Profit can be obtained by aggressively cross-selling additional services that complement a main product at premium margins; bundling or selling higher margin accessories and related products; and engaging customers in deeper and more extensive supplier-customer relationships with multiple products, services and points of contact.
Smith distinguishes between two characteristics of customers: price sensitivity and cost-to-serve. Although customers in low-margin markets usually have high price sensitivities, still it might be possible to identify specialty buyers or buyers who have special needs that can be exploited by selling them customized bundles of goods and services. The higher margins that can be charged to such customers may outweigh their higher cost-to-serve. On the other hand, once a core group of customers has been identified, then it may be possible to sell them additional products at low marketing cost. Smith gives the example of U-Haul taht strategically sets low prices and margins on basic truck and trailer rentals to maintain a large mass-market base, but then promotes add-on anciallry productsa ans ercices offered and promoted to tis large base of self-serce customers, such as moving boxes, dollies, lifts etc.
High gross margin strategies:
For high gross margin products, customers have low pirce sensitivity and might even have low cost-to-serve because product differentiation has converted them into a loyal group of buyers. For such customers, an effective strategy might be to use intensive advertising to drive product sales volume across the entire market, regardless of the varying price sensitivities of different market segments and to aggressively use sales promotions and price discounting to stimulate sales volume because initial margins are large enough to permit discounting. Advertising, loyalty programs, innovation and distribution activities are used to reduce price sensitivity and to increase the likelihood of repeat purchases. Meanwhile such repeat purchases concurrently reduce the cost-to-serve, since marketing investments can be amortized over larger volumes. Many packaged goods companies like Kellogg, General Mills and Kraft General Foods use such a model in their breakfast cereals segments.