I first read about Ram Charan (or originally just “Ramcharan”) from CNN.com and looked up more about this intriguing person. I’m reading a book authored by him to improve my business acumen, and thought about writing this interesting thing I read today.
The business equation is: Return = Margin * Velocity
As one can easily see, Return is increased when you increase Margin or Velocity. Margin is the net profit (including after tax), meaning this is the true profit. Velocity is basically how fast you are making that money. If you sell shoes, how long does it take for you to sell all of your shoes in a single shoe rack in your store? Is your shoe rack empty by the end of the day? Or does it take you a whole month to empty that rack? And that’s velocity, the measure of how fast you sell stuff. The faster you move your shoes off the racks, the better.
Interesting thought on selling software: If you sell shoes, what do you do when your rack is empty? You obviously have to order more from your supplier. That will take time (the time you place the order, the time it takes for the order to be processed, and the time the mail carrier delivers it to you). Maybe you say that you can pre-emptively place orders before the rack is empty, but that’s additional risk, because what if the stuff arrives and it doesn’t sell? Then your money is tied up in all those unsold shoes. Now imagine software. You obviously don’t have the same “inventory” problem, like a shoe seller does. How cool!
Ok, back to what I was saying. Dell is an interesting company because it basically assembles PCs with parts it gets from its suppliers. It doesn’t really make it’s own peripherals too much, so it doesn’t really keep inventory. Most of what you order online, are then built behind the scenes, on the demand, after you click that “place this order” button from their site. In the year ending Jan 28th, 2000, Dell only had 50 computers “left over” that wasn’t sold!
Another thing Ram talks about is cost of capital. Essentially, if you are borrowing money from someone else, you’re paying that someone for the borrowed money. This money, for most publicly traded corporations include those from shareholders. You’re essentially borrowing money from the shareholders. They are shareholders precisely because the bought your stock and paid in cash, the money that goes into a corporation’s pocket.
Even if you broke even, meaning even if you got paid $100 from a customer and it cost you $100 for that sale (for stuff including sales, marketing, manufacturing, taxes, etc.), you are still essentially losing money, destroying shareholder value, because you borrowed that money, with an interest rate. You have paid a small amount for that initial $100, in order to make that product. Wall St. would not be happy. This was one of the yard sticks the famed CEO of GE used in the late 80′s to decide whether or not to sell a business division of GE.
Ram also said it’s interesting to look at your industry in general, and see how well they are measuring up against this R = M * V equation. Or maybe in other industries. You may not have all the answers but asking the right question helps. Senior execs from companies such as Pratt & Whitney are learning from Dell on how to meet supply and yet not hold any inventory. Not having your money frozen in some unsold product is a great competitive advantage over your competitors. Now you can use that un-tied money to invest or do other things!