Achieving a Higher Return on Assets: 3 Problems, 3 Solutions

Over the last 50 years, US companies have been battling a decrease in their asset profitability. Despite an improved economy, higher productivity from workers and technology, and larger profits, return on assets (or ROA) has been on a steady decline across the economy.

Procter & Gamble has seen their ROA decrease from 9.94% in 2010 to 5.43% in 2015. BASF, a chemical manufacturing company, saw about a 25% decrease in ROA from 2014 to 2015.

Organizations are anticipating higher revenue levels that will be fueled by the extensive growth in the healthcare industry, demands for chemicals, and a stronger manufacturing sector. While all of this seems like it will increase overall ROA, many manufacturing companies are failing to create enough value from their assets. Some challenges organizations face include volatile costs, lower lifecycles, and regulations and penalties.

In this article, we will explore the challenges that organizations are facing and offer solutions to help increase ROA. Organizations should not be fooled by the record profits unless they want to join Borders and Circuit City — each who showed record profits right up until their rapid decline that eventually led to liquidation. These ROA solutions might not have saved them, but they would have fared better.

ROA: 3 Problems, 3 Solutions

Problem: Volatile and Variable Costs

Organizations face two cost challenges: those that shift dramatically and those that are dependent on factors such as output. If not properly managed, these two costs can quickly erode any profits a company might gain. Let’s first look at volatile costs.

The cost of energy and raw materials can be extremely volatile. For example, natural gas is near an all-time low after reaching its height nearly two years ago. This movement has favored many organizations but, in the first two weeks of March 2016, natural gas prices saw a 12% increase. The problem many organizations are facing is not high costs but rather the volatility from one day to the next.

The second cost type, variable costs, are dependent on the level of output. For example, the cost of wood is a variable cost for an organization that manufacturers furniture. Especially companies in the manufacturing industry have high amounts of variable costs, and they must find the right output for profit maximization.

An increase in output can sometimes decrease profit. For example, increased output for a given machine will increase the probability of breakdown and require more maintenance and repairs. Many organization struggle with variable and volatile costs, but here are some solutions an organization can use to combat costs.

Solution: Hedge Expenses and Properly Plan

Planning is the foundation for successful cost controlling. Organizations that plan have better control over their volatile expenses and can decrease the cost of variable expenses. Successful companies use a hedging strategy in an effort to control for volatility and variability.

A strong hedging strategy is about constraining and predicting costs. In order to control variable costs, organizations should establish constraints or limits. For example, a manufacturing company that decides to extend their product line will need to order more inventory, hire more employees to stock, and purchase or convert equipment so it can increase production of other product lines.

By extending their product line, the company has increased their costs. The most efficient companies specialize or limit themselves to one product line. Of course, this level of dependency can create risk. So, organizations need to find a balance between limiting themselves and creating a dependence.

Organizations can limit the risk associated with dependency by predicting the future. There are so many software options for organizations to evaluate the future market demand, resource allocation, and more. Organizations can run what-if scenarios, glean insight into what the future will hold, and discover an optimal course of action given the future events.

For example, a cereal company like Kellogg analyzes future results and invest in future options in an effort to control their supply costs. If Kellogg believes that wheat prices will increase over the next year, they will purchase an option to buy wheat prices at their current prices. This shelters them from any increased expense they might incur from an increase in wheat prices.

A hedging strategy could be as simple as planning where to source supplies and creating a contingency plan in the event more supplies are needed. It could be as simple as implementing a preventative maintenance program. Or it could be as complex as trading future options on a weekly basis.

Problem: Low Useful Life Due to Constant Innovation

Growing up in a generation where I learned to use a computer shortly after elementary school, I love technology. My first cellphone was a flip phone and now I have a powerful, Internet-browsing smart phone that has far more capabilities than even the first computers.

Technology has increased communications across the supply chain, it can limit risks by calculating events, and has made production more efficient and effective. However, the rate of technological innovation has created many problems for companies that are facility intensive.

Companies spend significant time and money to add capacity through better equipment and more complex software. They spend more to develop and introduce new technologies that have a shorter relevance.

All of this decreases the lifecycle of equipment. As a result, organizations are spending more on technology but getting poor returns on each piece of equipment. For example, three decades ago, a certain manufacturing company could spend $100,000 for a new piece of equipment that would run for 10 years and produce $1,000,000 in goods. Now, companies buy a piece of equipment for $100,000 that they can only run for 3 years before it becomes outdated and they lose to the competition.

So what are organizations to do when they are faced with the constant need to update their equipment and continue to achieve high results?

Solution: Capture More Value Being Delivered to the Market

The advancement in technology has allowed organizations to deliver more value at lower costs to customers. For example, companies can compare prices for supply costs and run complex algorithms that use to take an extensive workforce to complete. Despite the potential value that technology offers, most organizations are failing to capture some of the increased value.

The problem is that companies are falling behind on their ability to implement technology to its fullest extent. For example, one of the leading causes companies have failed to implement advanced business intelligence and prescriptive analytics is that the technology is too complex to use for most employees, and talent is too scarce.

Organizations that want to capture more value from their tools need to recruit top talent or use software that leverages the latest analytics and makes it available to users of all levels of expertise. The cost of highly skilled workers will continue to cause pressure on the bottom line, which will erode an organization’s ability to capture value.

Organizations that are using optimization software that requires an expert operations researcher to use are failing to capture the maximum amount of value. These organizations are typically slower in decision making, fail to generate optimal supply chain solutions, and struggle to find proper resource allocation because they are dependent on finding top talent that can leave them crippled when they move on to another company.

The solution is implementing software that is easier to use. Executives should be able to use the software to make quick decisions without waiting a week for the data. Sales and marketing should be able to access data on customer demand so they can create more effective marketing programs. Adoption need to be universal if an organization want to improve their ROA.

Problem: Tighter Regulations and Penalties

Many manufacturing companies are facing increased regulations — layered one on top of another — that increases costs and slows growth in the manufacturing industry. Since 1998, manufacturing regulatory costs have increased by 7.6% per year, while output only grew by 0.4%.

Regulations will decrease petroleum output by 10.3% between 2012-2021, according to a study conducted by Manufacturers Alliance for Productivity and Innovation. The chemical industry will see an 8.8% decrease in output and the iron and steel industry will see a 7% decrease in output.

Regulations have become time consuming and differ just enough that keeping track of regulations can be an endeavor. If process manufacturing companies violate current regulations, then they can face steep penalties.

Solution: Increase Access to Reliable and Affordable Energy

Leaders in manufacturing must acquire access to reliable and affordable energy if they want to produce more and grow the economy. This means organizations must constantly innovate and seek other forms of energy. Organizations never know when new regulations will be added.

The oil industry saw the EPA increase its crackdown on methane emissions from oil and natural gas drilling to all existing wells. This will certainly increase the cost of energy. Organizations should deploy new solutions that allow for greater efficiency, increased productivity and environmental sustainability. Organizations should also encourage their governmental administration not to add more regulations that prevents their access to critical energy.

Closing Remarks

Many manufacturing companies are seeing an increase in revenue, but are failing to achieve the same return on assets (ROA). Increased challenges from variable and volatile costs, shorter technological life cycle and increased regulations are impacting the bottom line. To fight against these challenges, organizations need to hedge against the future, recruit and train top talent, and continue to innovate. This is not a small task. It is, however, critical if organizations are to survive in today’s complex and competitive environment.

Supply Chain Brief