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Chapter 15: General Motors, the DuPont Formula and Return on Investment
Overview
Although it may come as little consolation, the issue of balancing asset utilization with profitability has befuddled businesspeople since the beginning of commercial time. Always understood from an anecdotal perspective, the ability to quantitatively address the productivity versus profitability quandary was first presented at the turn of the 20th century by the DuPont Corporation.
In an industry characterized by vertical integration and heavy investment in both physical plant and inventories, the financial geniuses at DuPont developed a formula that allowed for the measurement of productivity and utilization in the same equation. First known as the DuPont formula, and subsequently referred to as return on investment, this calculation was perhaps the first and most significant step in focusing on supply chain execution.
Whereas the DuPont formula was first introduced at the company that bears its name, it did not come into vogue until it resurfaced at the General Motors Corporation in early 1917. With the possible exception of gun manufacturers (like Remington and Smith & Wesson), General Motors and Ford were the forerunners to the "multi-national" enterprise with which we are so familiar today. With manufacturing and sales operations in several countries, the General Motors management team had to deal with the same large-scale issues as contemporary supply chain managers: forecasting, pipeline visibility and inventory management.
The evolution of General Motors as well as the purpose of the DuPont formula are best described in the book My Years with General Motors by Alfred P. Sloan, Jr. Published in 1963, the book chronicles the period from 1918 to 1946, during which Mr. Sloan joined GM and eventually became president and CEO of the corporation. Described by Bill Gates as "the best book to read if you only want to read one book on business," My Years with General Motors planted the seed for the evolution of business management as both discipline and profession.
Even though the book touches on important topics like competitive analysis, customer financing and risk management, for purposes of the discussion at hand GM's greatest contribution comes in the form of recognizing the importance of synchronizing profitability with asset utilization. In that vein, and perhaps unbeknownst to the author, My Years with General Motors remains the best book ever written on the relationship between supply chain execution and financial management.
Operating at a time when access to real-time information was non-existent, the GM team got to the core of the issues it faced with objectivity and resolve, setting the foundation of business principles that are still in use today. Obsessed with the importance of balancing inventory levels with forecast and actual sales, the book is rife with allusions to inventory management. Not unlike most innovations in business, introduction of the DuPont formula at GM was in response to a crisis.
Based on forecasts carried out in 1919, GM had set production schedules 36% higher than the preceding budget period. In anticipation of this growth, GM's finance team set about arranging the sale of $64 million in stock to finance the purchase of raw materials and additional plant capacity. As 1920 unfolded, the minutes of a meeting held in May clearly displayed management's concern with continued expenditures in plant and equipment and inventories rising above a $150 million ceiling that had been set earlier in the year. [1] For reasons unknown to GM management, the situation got worse, with expenditures continuing down the wrong path. The situation had become what Mr. Sloan referred to as "decentralization with a vengeance."
These events depict one of the world's first multi-national corporations as deeply concerned with the relationship between assets and profitability. Equally profound, however, are the overtures in the book regarding the poor reliability of forecasts and how increasing inventories can force a company's financial hand, sending it to the market for additional funds. All these points should sound familiar to today's businessperson, although there is little comfort in knowing that not much has changed in human nature or business over the last 80 years. In fact, if someone were asked to read certain chapters from the book without knowing its name, author or historical context, he or she would be easily convinced that they were fresh off the business press and not from a book about business in the 1920s.
As it turns out, GM's forecast for 1920 was way off and did not anticipate a precipitous drop in purchases that year. Consequently, inventories increased from $137 million in January to $209 million in October. The ripple effect alluded to throughout the NikoTech analysis is by no means a new phenomenon, and GM quickly learned how inventory management affects all areas of a business. With so much money tied up in inventories, by October of 1920 GM managers were hard-pressed to pay suppliers and even their own payroll. In response to this crisis, the record shows that GM was compelled to borrow $83 million in short-term notes to meet its obligations. [2] By that point, not only did the income statement suffer from a lack of sales but the problem had found its way into the balance sheet in both inventories and notes payable.
The combination of profit pressures and a hurting balance sheet left Mr. Sloan and his team with few options. Because the GM team had almost zero visibility into existing and pipeline inventories, the only real option was to stop the presses completely. Under executive order from Mr. Sloan's office, all purchase orders were canceled until such time as exact inventory levels could be determined. While negotiations with suppliers were tough, most understood the severity of the situation and, in the best interest of the supply chain, went along. From there, GM conducted in depth analysis to determine what it had in stock, ascertain what purchase orders had been released with their corresponding receipt dates and compare both with the requirements of a considerably reduced production schedule. Once the floodgates were turned back, execution of the inventory reduction plan continued with a four-month rolling forecast.
By working much closer with the dealers to estimate demand, GM production planners were able to level the inflow of materials and production and thus begin to drive down historical inventory levels. Although a painful process, the GM team was eventually able to reduce inventories from a September 1920 high of $215 million to $94 million in June 1922. By that time, GM also noted that its inventory turnover ratio had improved to four times per year. [3]
In addition to the drastic measures taken by GM at an operating level, of equal interest were the allusions made to why such measures were taken in the first place. Very similar to what modern-day corporations experience, inflated inventories squeezed cash flow, a situation that prevented divisions from making payroll and accounts payable. Also, GM not only issued stock to finance the purchase of plant and inventories, it then had to take on short-term notes to meet the aforementioned obligations. Taking into consideration the GM inventory overflow and a depressed market because Ford had stashed prices by 30%, it's no wonder that the GM management team placed so much importance on the reconciliation of profit with asset utilization.
Fueled by the economic circumstances in which it found itself, the GM management team decided to implement the DuPont formula across all divisions. The pivotal idea management had to sell to the divisions was that the formula was perfectly suited to measure the organization's goal of balancing net income with asset utilization. The isolation of these variables is achieved by multiplying the quotient of the return on sales ratio with that of the total asset turnover ratio. For purposes of this discussion, note that total asset turnover already has been discussed as a discrete measure and is now being incorporated into the DuPont calculation. First mentioned during the Introduction to this book and detailed in Figure 15.1, the DuPont formula is
Net income/Sales x Sales/Total assets
Figure 15.1: Return on Investment Calculation
The DuPont formula was brought to GM by Donaldson Brown, a former executive of the DuPont Corporation who later became chief financial officer at GM (at that time, DuPont had a large interest in GM stock; hence the relationship). Also known as return on investment (ROI), the formula was found to have immediate strategic and tactical applications in creating the balance between profitability and asset management. Relative to ROI, asset management and the causal relationships inherent to business operations, Mr. Sloan said:
Rate of Return, of course, is affected by all the factors in the business; hence if one can see how these factors individually bear upon a rate of return, one has a penetrating look into the business. [4]
This excerpt makes it very clear that executives have been aware of the need to align balance sheet and income statement performance for close to a century. Simple math, on the other hand, does the best job of making this point. The most obvious observation one can make about the DuPont formula is that the denominator in the net margin equation and numerator in the asset turnover equation are the same, net sales. Basic algebra dictates that this variable cancels itself out, leaving a new equation that reads:
Net income/Total assets
The obvious temptation for any manager or financial analyst is to skip the net margin and asset turnover calculation and move directly to calculation of the ROI figure. However, in the spirit of being thorough, the analyst must realize that he or she should never skip a step in the measurement process because it may eventually leave causes of waste in the supply chain unidentified. Instead, the thorough manager will break down the components of each equation, endeavoring to trace financial results back to operating tactics. This exercise is precisely what Mr. Sloan was alluding to when he stated, "Essentially, it was a matter of making things visible."
If My Years with General Motors is the only book to read on business, then the only chapters to read on financial management and supply chain execution are from the excerpts alluded to here. Considering that these events took place in the 1920s in an industry that altered our world forever, the insights of industry's first supply chain pioneers are amazing. In straightforward prose, Mr. Sloan and his team were able to identify the root causes of problems and work systematically to eliminate them. They also understood the financial links that existed between operational challenges and poor financial performance. It was their interpretation of this financial information that led them to confront most of their operational issues and turn GM into the largest corporation in the world at that time.
Of equal relevance in today's global environment, the "aggregating and deaggregating of figures" speaks precisely to tracing the impact of lead times, landed costs and inventory levels to the individual and overall effect on financial reports. Perhaps in this context a look into the issues of the past is a consolation and, better yet, a guide to today's supply chain executive. One would venture to guess that certainly would be so in the case of NikoTech.
[1]Alfred P. Sloan, Jr., My Years with General Motors, Doubleday, 1963, p. 30.
[2]Alfred P. Sloan, Jr., My Years with General Motors, Doubleday, 1963, p. 31.
[3]Alfred P. Sloan, Jr., My Years with General Motors, Doubleday, 1963, p. 125.
[4]Alfred P. Sloan, Jr., My Years with General Motors, Doubleday, 1963, p. 141.
