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Much has been said about financial ratios and related analysis.
I have written about the
Dupont formula
and liquidity and solvency-oriented ratios (
here
, and
here
) for understanding the finances of a business.
But there are limits to purely financial analysis.
For example, I am currently working with a client in the temporary staffing business. He knows his business is cyclical and wants some expense ratios based on either sales or gross profits to judge operating expense levels. The challenge with such ratios is they don’t consider price or quantity. So while he may know that a particular cost as a percent of revenue went down, he can’t tell if it’s because that expense now costs less, or because prices were increased. He knows
something
has changed, but not just what.
This is why
looking at income statement items on a volume-adjusted basis is very helpful
— something that requires a
nonfinancial
measure of volume. This month, we look at how to do that and consider other quantity-related measures.
For some industries, particularly manufacturing, volume measures are simple and obvious. When I was in the pulp and paper industries, we looked at paperboard in “dollars per ton.” Price, cost elements, and so forth were all analyzed that way. On the corrugated box side, tons came in and square feet of corrugated came out. We evaluated everything as “dollars per thousand square feet (MSF)” of corrugated.
When I was in the food business, the common measure was a bit less obvious.
We made food that was put in jars and measured in pints. Dry food was packaged in boxes and measured in pounds. So, we measured the aggregate in pounds/pints. Yes, we added apples and oranges together, but the measure worked well enough and was better than the alternatives. (We didn’t measure in cases, a common measure, because there was too much variation in case size.)
These measures proved helpful for quick analyses.
For example, in the corrugated business, if the price per MSF of corrugated went up, we knew it was either due to a higher margin business or business with more raw materials. So we also measured the standard weight of the corrugated in pounds per MSF. A higher pounds per MSF meant customers ordered corrugated that used more raw materials so there was more cost. A percentage of sales or some other financial number could not have provided that insight.
Sometimes,
more than one measure of sales volume is needed.
When I was in the car rental business, we used
both
cars and Daily Billed Revenue (DBR) days. The former, because some costs (e.g., depreciation and interest) were fixed on a per car basis. The latter, because costs such as maintenance, insurance, and body damage varied as a function of DBR days. So we had to look at both.
A few pointers…
Understand the data.
Particularly if you are new to a company,
look into the data
and understand
how it is collected
. Even industry standard measures such as DBR days vary by company.
Maintain data integrity.
If a volume metric is important, put
processes and controls
in place to ensure the data is available promptly and that it is trustworthy.
Look beyond sales volume metrics.
A common measure is sales and expenses per full-time equivalent employee (FTE). In my car rental days, one of our competitors (Alamo) went further than FTE measures and tracked “up-sale dollars per hour,” by agent, in real time. If an employee was having a bad up-sale day, they were sent home.
Measure volumes that relate to core strategies.
Alamo’s strategy was to avoid costly airport concession fees by operating “off airport.” It also meant Alamo was a customer's only viable off airport choice. This combination allowed Alamo to sell on price to the leisure market while taking full advantage of up-sale opportunities. For example, that low fare often came with a car unable to hold all your luggage comfortably (if at all). This was a deliberate strategy and only possible due to Alamo’s ability to track up-sales in real time in a disaggregated fashion (i.e., up-sales per agent).
Track quantities by
critical constraint
.
A critical constraint is something that limits how much a business can make or sell. In manufacturing, it is often machine time for the one machine that is always fully booked. During the pandemic, new critical constraints often emerged, such as people or raw materials. The key here is to make the most profitable products or provide the most profitable service per unit of the critical constraint.
Dollars Alone Are Not Enough
Every business runs on dollars. But when tracking performance and working to maximize the output of critical measures,
it is important to look beyond just purely financial indicators and consider other factors as well.
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