The Du Pont Model: Evaluating Alternative Strategies in the Retail Industry

Abstract

INTRODUCTION The Du Pont model is a timeless and elegant model of financial analysis that has been used by analysts and educators for almost a century. Most academic or professional books on financial analysis use some form of Du Pont model to provide insight into return on assets (ROA) or return on equity (ROE). An effective presentation of Du Pont model can be found in a book by Palepu and Healy (2008), who use a modified version of DuPont to evaluate management's execution of competitive strategy. They hypothesize a connection between Du Pont factors, net operating income to sales and turnover ratios, and a firm's competitive strategy (cost leadership or differentiation). For example, a cost leader like Wal-Mart may generate a relatively low net operating income to sales but balance that against a relatively high turnover. In contrast, a differentiator such as Target may be successful by generating a relatively high net operating income to sales and a relatively low turnover. Conventional wisdom is that companies can devise successful competitive strategies around either profit margin or turnover. The purpose of this paper is to examine financial performance of retail firms through use of a modified Du Pont model of financial ratio analysis and to identify drivers of financial success under alternative business strategies. Firms in retail industry are categorized according to their high/low relative net operating income to sales and turnover ratios. Firms with high relative net operating income to sales and low relative turnover are assumed to be pursuing a differentiation strategy and those with high relative turnover and low relative net operating income to sales are assumed to be pursuing a cost leadership strategy. The performance variable used is return on net operating assets. BUSINESS STRATEGIES Strategy can be defined as the direction and scope of an organization over long term, in order to achieve advantage for organization through its configuration of resources within a changing environment, to meet needs of market and to fulfill stakeholder expectations. (Johnson & Scholes, 2002, p.10.) In essence, strategy defines a company's competitive stance within an industry. A widely recognized model for characterizing business-level strategies is Porter's (1998) generic competitive strategies. He identifies three strategies, cost leadership, differentiation and focus. For our purposes, these can be narrowed to two, because a focus (niche market) strategy is either cost leadership or differentiation-based (Price & Newson, 2003). Cost leadership strategy attempts to achieve organizational goals by delivering a product or service comparable to competitors' at a lower cost to customer. Firms pursuing this strategy maintain tight controls on costs and often look for economies of scale and sales volume. Palepu and Healy (2008) suggest that a firm pursuing cost leadership strategy may generate a relatively low profit margin but balance that against a relatively high turnover. Soliman (2008), in his analysis of components of Du Pont method, while not using cost leadership/differentiation terminology explicitly, clearly suggests their existence. He states that turnover measures asset utilization and efficiency, efficient inventory processes and working capital management (p. 824). He offers Dell Computers as example of this business model. A differentiation strategy, alternatively, attempts to deliver to consumers some characteristic of product or service that will command a premium price. Examples of such characteristics include brand name, quality, service, design, delivery method and variety. Companies pursuing a differentiation strategy must balance expenditures for marketing and R&D with ability to price their product/service competitively against others in same market (Palepu & Healy, 2008). …