Growth or expansion?
In the last 10 years, Indian manufacturing organizations have shown remarkable growth whether we look at their revenues, profits, or cash flows. During the last 9 years, Mahindra and Mahindra Limited, the largest manufacturer of agricultural tractors and utility vehicles, increased its revenues by 330%, and profit before tax (PBT) by about 500%! Similarly Dabur India, a leading consumer goods organization in health care increased its sales by about 240% and PBT by 700% from 1998-99 to 2007-8. The performances of these organizations seem quite impressive, and one can safely comment that these are really growing organizations.
Are we really sure that these organizations are growing? What is our criterion for declaring a company as a growing company? If we consider increase in revenue, market share, PBT or PAT as the criterion, then we can definitely conclude that these companies are growing. However when we use the term Growth we need to understand clearly this term. In the general colloquial terms, any increase could be called growth. However we would like to define Growth as “Doing more with same or less resources.” With this definition of Growth, we also need to explain what we understand by Expansion. Expansion is increasing output with simultaneous increase in inputs.
Let us apply our definition of Growth and Expansionto manufacturing industry and understand the implications.
What is the output of any manufacturing organization? It could be vehicles, equipment, medicines, shoes, shirts, toys, or any product that the organization makes and sells in the market. In order to manufacture any product, the organization needs to purchase either some raw materials and process the same to a finished product, or buy components and assemble them to a finished product. Can we say that the output of the organization is the finished products that it sells in the market? Let us understand this through an example. An organization imports photographic film in bulk and repackages this in small packages of 24 or 36exposures. Can we say that the output of this organization is the photographic film or the package of the film?
Most people will call this repackaging. Is it possible to create a generic definition for output of all manufacturing organizations? In order to create output or make products an organization requires various inputs like materials, machines, and men (This includes women too!). The real output of the organization is the value addition it creates by processing materials it procures from its suppliers through the men it employs on the machines purchased by its money. In very simple terms this could be defined as the revenues less all materials consumed. Of course sales tax, and excise duty are also to be subtracted from sales for working out value addition. We could term it as Throughput (T).
When we ask an owner or CEO of an organization regarding the performance of his organization for the last year, last quarter or last month, typical answer is “We had 20% growth in sales or we increased our market share by 5%”. From this answer, we cannot conclude that value addition or Throughput has also increased by 20%. It could be more, same or even less!
Let us illustrate this through an example. A computer assembling organization Computers India sold 100 computers at a price of Rs. 10,000 per computer last month. The total sales for the last month were Rs. 1,000,000. The material cost per computer is Rs. 8,000. Hence the material cost of 100 computers sold in last month was Rs. 800,000.Accordingly the throughput for last month was Rs. 1,000,000 less 800,000 i.e. Rs. 200,000. In order to increase sales, Computer India launched a special scheme for one month only offering a 10% discount. The new sales price of Rs. 9,000 caught the fancy of the customers and its sale increased by 50% from 100 units to 150 units. The total sales for the month will now be Rs. 1,350,000. The material cost for 150 computers @ Rs. 8,000 per computer works out to be Rs. 1,200,000. The throughput for the month will be Rs. 1,350,000 less Rs. 1,200,000 i.e. Rs. 150,000. While sales increased by 35% in value terms (or 50% by quantity), throughput actually shrunk by 25%! Similarly increased market share does not imply that throughput has also increased. We are not at all suggesting that all market share increase or sales increase through price changes will always reduce throughput! At the same time one should not also assume that all increases in sales will automatically result in increased throughput.
So far we have defined the output of an organization. We also need to identify what inputs an organization requires to create output.
One input is the people (men) that an organization requires for working on various processes both technical as well as administrative. The organization has to pay salaries to its people along with other expenditure that is required for the people. We club together all expenses other than totally variable cost (material cost) as Operating Expenses (OE). The other input that the organization uses is the money or all the money deployed for carrying out the business activities. This includes money required for acquiring land, building, plant and equipment, inventories, money to be collected from customers, advances to suppliers etc. In short all the organization money that cannot be cashed instantly. We call it Total Capital Employed or Investment (I).
Now let us return to the subject of Growth and its measurement. As per our definition, Growthis creating more with same or less resources. Hence an organization that creates more output i.e. Throughput (T) with the same resources i.e. OE or Investment (I), should be considered as a growing organization. Accordingly Growth could be measured by the following two parameters.
T/OE ~ People productivity (PP), and
T/I ~ Capital productivity (CP)
Now an organization will be considered growing organization if at least one of these two parameters (T/OE) and (T/I) are increasing continuously.
Let us also substantiate that any organization that is growing as per our definition will also simultaneously increase its profits and return on investment (ROI) or return on capital employed (ROCE).
In order to link profits and ROI/ROCE to growth, we need to understand the linkage between T, OE, I, Profit, & ROI/ROCE.
Profit = Revenue less all expenses, or
= Revenue less (variable cost i.e. material cost) less Operating expenses, or
= (Revenue less variable cost) less (Operating Expenses).
Earlier we had defined value addition or Throughput (T) as revenues less variable cost
Hence Profit = T-OE
= OE X (T/OE-1)
Substituting T/OE as PP, we will get
Profit = OE X (1-1/PP)
Now ROI = Profit / investment
= (T-OE) / I
= T X (1-OE/T)/I
= (T/I) X (1-1/(T/OE))
When we substitute T/OE by PP (People Productivity) and CP (Capital Productivity) in the above, we will get
ROI = CP X (1-1/PP)
One can observe that Profits and ROI will definitely increase even when only PP improves with all other parameters remaining same. Additionally improvement in CP will further increase ROI.
Let us evaluate the growth performanceof the two exceedingly successful organizations mentioned earlier.
We examined the financial data of the Mahindra and Mahindra Limited and Dabur India Limited for 10 years from 1998-99 to 2007-8.The analysis is shared below
Mahindra and Mahindra Limited
Net sales increased by 3.3 times at a CAGR (Compounded Annual Growth Rate) of 14% in 9 years.
Profit before taxincreased by 5 times over the last 9 years at a CAGRof 20%.
Throughput increased by 3 times at a CAGR of 13%
- T/OE improved from 1.29 to 1.77 at a CAGR of just 2%per year
- T/I improved from 0.42 to 0.64 at a CAGR of just 3%per year
Dabur India Limited
Net sales increased by 2.4 times at a CAGR of 10% in 9 years.
Profit before tax increased by 7 times over the last 9 years at a CAGR of 24%.
Throughput increased by 2.8 times at a CAGR of 12%
- T/OE improved from 1.06 to 1.33 at a CAGR of just 3%per year
- T/I improved from 0.76 to 1.2 at a CAGR of 5%per year
Once again we can observe that primarily the increase in various parameters was achieved through expansion rather than improvement in productivity.
Had both these organizations improved their people productivity (PP) by 10% per year, their profits would have been more by about 5 times their current profits!
We are not at all propagating that expansion is bad and increase must happen only through productivity improvement. However we must first look at improving people productivity and capital productivity (Growth) before adding resources, be it men, money or machinery (Expansion).